Investments

INVESTMENTS
BY
DAVID F. JORDAN
LATE PROFESSOR OF FINANCE
NEW YORK UNIVERSITY
AND
HERBERT E. DOUGALL
PROFESSOR OF FINANCE
STANFORD UNIVERSITY
SIXTH EDITION
New York
PRENTICE-HALL,
1952
INC.
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SOCIAL SCIEHCE9
Copymcht, 1920, 1924, 1934, 1941, 1952, by
PRENTICE-HALL, INC.
70 Fifth Avenue, New York
Copymcht, 1933, by DAVID F. JORDAN
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MAY BE REPRODUCED IN ANY FORM, BY MIMEO-
GRAPH OR ANY OTHER MEANS, WITHOUT PERMIS-
SION IN WRITING FROM THE PUBLISHERS.
First Printing September, 1919
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FIRST REVISED EDITION
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SECOND REVISED EDITION
Fourteenth Printing August, 1933
THIRD REVISED EDITION
Fifteenth Printing August, 1934
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Twentieth Printing August, 1939
Twenty-first Printing June, 1940
FOURTH REVISED EDITION
Twenty-second Printing June, 1941
Twenty third Printing February, 1942
Twenty-fourth Printing January, 1946
Twenty-fifth Printing May, 1946
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Twenty-seventh Printing .... September, 1946
Twenty-eighth Printing February, 1947
Twenty-ninth Printing July, 1947
Thirtieth Printing November, 1947
SIXTH EDITION
Thirty-first Printing May, 1952
L. C. Cat. Card No. 52-8603
PRINTED IN THE UNITED STATES OF AMERICA
PREFACE TO SIXTH EDITION
Many changes have taken place in the whole field of investments
since the late Professor Jordan published the 1941 edition of Jordan
on Investments. Had he lived, Professor Jordan would most certainly
have revised his pages to reflect the influence of World War II and its
aftermath, the shifts in the capital and securities markets, the growing
influence of regulation, the increased interest in common stocks as in-
vestment media, and many other developments. It is the hope of the
new co-author that the revisions made in the light of these developments
do not detract from the spirit and purpose of the previous editions, or
from the clarity of style and presentation that characterized Professor
Jordan's original text.
The revisions made in this edition have been very thorough, with
respect to both organization and subject matter. The more important
of these are as follows:
The book is now divided into five parts. Part I includes the intro-
ductory discussion of the nature of investment; Part II is devoted to a
survey of the media of investments, Part III to investment principles
and programming, Part IV to investment mechanics and the invest-
ment markets, and Part V to investment analysis.
A new Chapter 2, containing general classifications of investment
media, is introduced prior to the separate descriptions of the major
types.
The material on savings institutions and savings bonds, discussed in
earlier editions in connection with investors of limited means, has been
given expanded treatment in Part II. While these types have a special
appeal to the small investor, their importance is by no means confined
to this category.
Chapters 7 and 8 of the new edition develop in considerably greater
detail the discussion of investment principles found in previous editions
under the chapter headings "Protection in Purchasing" and "Protection
in Holding." The discussion of corporate reorganization, formerly lo-
cated in a separate chapter, has been included in the new edition in the
chapters dealing with railway and industrial securities.
The previous chapter on institutional investors has been expanded to
two chapters in the present edition to reflect the increased importance
of these groups and the changes in regulations governing the invest-
ment of their funds.
The chapter on individual investors expands the point of view of the
chapter previously devoted to the investor of limited means, to a con-
sideration of investors of various types and classes.
The revised chapters on sources of information and the financial
page have been placed ahead of the material on investment banking
and securities markets, and the discussion of sources has been ex-
panded to reflect the growth in available investment information.
M760170
iii
iv
PREFACE TO SIXTH EDITION
In the revised chapters on investment banking and securities mar-
kets, an attempt has been made to cover the many changes in tech-
niques and regulation that have taken place in these areas during the
past decade. The former chapter "Brokerage Orders" has been re-
named "Buying and Selling Securities," and the latest developments
have been incorporated.
The material on investment mathematics is illustrated with more
modern bond tables. And, of course, it has been necessary to revise
completely the treatment of the impact of taxation on investment poli-
cies. The reader will appreciate that further changes in the tax laws
will have taken place subsequent to the writing of this revised chapter.
As would be expected, developments in the past decade have necessi-
tated a very comprehensive revision of the chapters devoted to securi-
ties analysis. At the price of expansion of the material, an effort has
been made to include the impact of recent economic changes and in-
vestment thinking in the discussion of the major types of securities. The
most significant structural revision is found in the allocation of separate
chapters to bank, insurance company, and investment company securi-
ties. The increased attention given to the latter group reflects their
increased importance during the past 10 years. The chapter on foreign
securities has been relocated after the discussion of domestic civil
issues.
A great many persons have contributed to the revision of this book.
The new co-author must echo the sentiments of Professor Jordan in
acknowledging the stimulus of many classes of fine students over the
years. Former colleagues and continuing friends at Northwestern Uni-
versity, especially the "dean" of teachers of finance, Harry G. Guth-
mann, and associates at Stanford University Graduate School of
Business, have provided many ideas and constructive suggestions in
discussions of finance over the years. Appreciation is due the following,
who have been so kind as to read certain sections of the revision and to
clarify many points from the viewpoint of practitioners in the field: E. T.
Coman, Jr., Director of Libraries, University of California at Riverside;
Robert L. Cody, Vice-President, Commonwealth Investment Company;
Charles H. Gushee, President, Financial Publishing Co.; Walter C.
Gorey, of Geyer & Co.; J. A. Doucournau, Vice President, and George
A. Hopiak and H. C. Tasto, of the Wells-Fargo Bank and Union Trust
Company; John Inglis, Vice President, Blyth & Co., Inc.; Richard W.
Lambourne, partner, Dodge & Cox, investment managers; Professor
Dan M. McGill, of the University of North Carolina; Kenneth H. Sayre,
partner, Irving Lundborg & Co.; and Norman Strunk, Executive Vice
President, United States Savings and Loan League. Professor Douglas
H. Bellemore, Chairman of the Department of Economics, Boston
University, read the entire manuscript and made many constructive
suggestions.
H. E. D.
CONTENTS
PART I
Introduction
APTEK PAOE
1. THE NATURE OF INVESTMENT 3
Scope; Economic and financial aspects of investment; Invest-
ment versus speculation; The supply of new capital; The pro-
ductive employment of capital; The demand for new capital;
The return on investments; Scope of the book.
PART II
Investment Media
2. TYPES OF INVESTMENTS:
GENERAL CLASSIFICATIONS 15
Scope; Classification by general type or group: Savings group,
Securities group, Real estate proper; Other classifications.
3. SAVINGS INSTITUTIONS AND SAVINGS BONDS . 25
Scope; The growth of savings. 1. Postal Savings Deposits.
2. Time Deposits in Commercial Banks. 3. Deposits in Mutual
Savings Banks. 4. Accounts in Savings and Loan Associations.
4. SAVINGS INSTITUTIONS AND SAVINGS BONDS
(CONTINUED) 38
5. United States Savings Bonds. 6. Life Insurance and Annuities
as Investments: The investment aspects of life insurance; Types
of policies from the investor's point of view; Investment merits;
Annuities as investments.
5. CHARACTERISTICS OF CORPORATE BONDS . . 51
Scope; General characteristics; Reasons for issuing bonds; Im-
portance of bond financing; Bond indentures; The bond instru-
ment; Titles based upon security; Titles based upon purpose of
issue; Titles based upon form of issue; Titles based upon redemp-
tion; Titles based upon participation; The investment position of
bonds.
vi
CONTENTS
6. CHARACTERISTICS OF STOCKS 71
Scope; General characteristics; Legal position of the stockholder;
Stock terminology; Preferred stockgeneral nature; Preferred
stock protective provisions and voting rights; Classified common
stock; Preferred stocks as investments; Guaranteed stocks; Com-
mon stock; Dividend policies; Advantages of common stocks as
investments; Disadvantages of common stocks.
PART III
Investment Policy and Management
7. INVESTMENT PRINCIPLES 93
Scope; Steps in investment planning; Determination of invest-
ment objectives; Investment requirements or considerations;
Types of investment risk.
8. INVESTMENT PRINCIPLES (CONTINUED) ... 118
Scope; Methods of minimizing risk; Management of investments
by others; Safekeeping of securities.
9. INSTITUTIONAL INVESTORS 134
Scope; Restrictions on institutional investment. 1. Commercial
Bank Investments: Commercial banks as investors; Types of
bank assets; Investment restrictions; Significance of investments
as assets; Investment policies; Profits and losses on securities;
Other bank investments. 2. Savings Bank Investments: Gen-
eral investment restrictions; Legal investments in New York
State; Shifts in investment policy. 3. Investments of Savings and
Loan Associations: General investment characteristics; Legal
restrictions on investments; Secondary markets.
10. INSTITUTIONAL INVESTORS (CONTINUED) . . 152
4. Trustee Investments: Nature of a trust; Types of personal
trusts; Corporate trustees; Legal restrictions on trust invest-
ments; Common stocks as trust investments; Common trusts;
Investment procedure. 5. Investment of Endowments. 6. Life In-
surance Company Investments: Scope of the industry; Sources of
funds for investment; Investment restrictions; Newer forms of
investments; Investment policy.
11. INDIVIDUAL INVESTORS 171
Scope; Review of investment media; Factors making for indi-
vidual differences; Application of investment principles; Illustra-
tive situations: Investments of the young family, The established
professional man, The established business man, The widow or
retired couple, The wealthy investor. ,
CONTENTS
vii
PART IV
Investment Mechanics
CHAPTBB PAGE
12. SOURCES OF INVESTMENT INFORMATION . . . 187
Scope; The tools of investment; Daily business and financial
papers; Weekly business and financial periodicals; Monthly busi-
ness and financial periodicals; Quarterly investment and finan-
cial periodicals; Banking periodicals; General periodicals; In-
formation on United States Government securities; Information
on state securities; Information on municipal securities; In-
formation on industriesgeneral; Information on companies and
their securitiesgeneral; The statistical and rating services; In-
formation on railroads and railroad securities; Information on
public utilities and their securities; Information on financial in-
stitutions and their securities; Information on real estate securi-
ties; Information on foreign securities; Security market fore-
casts; Investment advice.
13. INTERPRETING THE FINANCIAL PAGE .... 203
Scope; Financial reporting; Quotations on United States Govern-
ment obligations; Listed bond price quotations; Listed stock
price quotations; Over-the-counter quotations; Other informa-
tion on security prices and volume of trading; Security price
averages; Money rates; Business and price indexes; Corporate
earnings reports; Commodity prices; Other information.
14. INVESTMENT BANKING 213
Scope; Direct sale of securities; Economic function of investment
banking; Types of investment banking houses; Internal organi-
zation; Private negotiation and competitive bidding; The buy-
ing function; The underwriting of securities; Pricing the issue:
the underwriters' "spread"; "Best-efforts" selling; "Stand-by"
underwriting; Selling the securities; The advisory function; The
protective function; The service function; Federal regulation of
security selling; Special Federal securities regulation; State
securities regulation.
15. SECURITIES MARKETS 238
Scope; Functions and classes of securities markets; Function of
the exchanges; Advantages of listing to the investor; Organiza-
tion of the exchanges; Operations on the New York Stock Ex-
change; Securities Exchange Act; The Securities and Exchange
Commission; Registration and regulation of exchanges; Registra-
tion of listed securities; Regulation of dealers and brokers; Re-
port requirements; Trading by "insiders"; Proxies and their
solicitation; Credit control; Manipulation of prices; Special offer-
ings and secondary distributions; Unlisted trading privileges;
The over-the-counter market.
viii
CONTENTS
16. BUYING AND SELLING SECURITIES 255
Scope; Buying and selling orders; Buying new securities; Buying
and selling unlisted securities; "Market" and "limit" orders; Day
and open orders; Stop-loss orders; Function of the specialist;
Odd-lot orders; Short selling; Privileges and options; Buying on
margin; Trading in rights and warrants; Buying and selling
listed bonds; Time of delivery; Commission charges; Transfer
taxes and Federal registration fees; Transfer of securities.
17. MATHEMATICS OF INVESTMENT 271
Scope; Investment mathematics; Mathematical terms; Accrued
interest on bonds; Bonds sold "flat"; Accrued dividend on stocks;
Yields on stocks; Yield on bonds; Compound interest formula;
Present worth formulae; Bond tables; Yields on callable bonds;
Convertible securities; Subscription rights; Stock-purchase
option warrants.
18. TAXATION OF INVESTMENTS 289
Scope; Taxes on securities; Federal personal income taxes; Capi-
tal gains and losses; Federal personal income taxes on divi-
dends; Corporate income taxes; State income taxes; Federal
estate taxes; Federal gift taxes; State estate and inheritance
taxes; Investment significance of estate and inheritance taxes;
Property taxes; Transfer taxes on securities; Taxation of insur-
ance proceeds, annuities, and pensions.
PART V
Analysis of Securities
19. UNITED STATES GOVERNMENT SECURITIES . . 305
Scope; Short history of the Federal debt; The Federal debt
structure in 1951; Description of major types of debt; Federal
instrumentalities; Territorial bonds; Investment tests; The test
of willingness to pay; Other investment criteria; Tax position
of Government bonds; Price and yield record of Government
bonds; The market for Government bonds.
20. STATE BONDS 324
Scope; Amount and growth of state debt; Types of state debt;
Purposes of issue; Sources and uses of revenue; State sover-
eignty; Ability to pay; Willingness to pay; Tax-rate limitations;
Legality of issue; Tax status of state bonds; Yields on state
bonds; The market for state bonds; Investment position of state
bonds.
CONTENTS
ix
21. MUNICIPAL BONDS 336
Scope; Classification of municipal agencies; Sources and uses of
municipal revenues; Purposes of issue; Growth of municipal
debt; Nature of municipal obligations; Ability to pay; Willing-
ness to pay; Legality of issue; Form of municipal bonds; The
market for municipal bonds; The tax position of municipal
bonds.
22. FOREIGN SECURITIES 366
Scope; Types of foreign investment; Volume of private foreign
investment; The appeal of foreign securities; Special factors
in foreign security analysis; Public issues; Defaults on foreign
public issues; Foreign corporate issues; Barriers to the revival of
private foreign investment; Protective agencies; The "World
Bank"; Prices and yields of foreign bonds; Investment position
of foreign bonds.
23. GENERAL TESTS OF QUALITY:
CORPORATION SECURITIES 384
Scope; The traditional meaning of quality; Defects of the
traditional concept of quality; A revised concept of investment
quality; The measurement of quality; Tests of "internal" risk;
Other factors affecting recovery of principal; Other factors affect-
ing income and yield; The factor of marketability.
24. RAILROAD SECURITIES 401
Scope; Development of the industry; Regulation; Railroad sys-
tems; Geographical influences; Operating data; Income state-
ment analysis; Balance sheet analysis (assets); Balance sheet
analysis (liabilities); Railroad bonds; Railroad stocks; Consoli-
dations; Reorganization; Future prospects; Railroad securities
analysis.
25. PUBLIC UTILITY SECURITIES 439
Scope; The utility industries; The franchise; Regulation; Terri-
torial analysis; The factor of management; Public ownership
and public competition; Balance sheet analysis; Types of securi-
ties; Income statement analysis; Electric light and power; Sum-
mary of power company tests; The gas industry; Gas company
analysis; The telephone industry; Telephone company analysis;
The telegraph industry; Telegraph company analysis; The water
industry; Water company analysis; The local transit industry;
Street railway company analysis; The holding company; Hold-
ing company analysis; Public Holding Company Act of 1935;
Investment outlook and market standing; Securities analysis.
26. INDUSTRIAL SECURITIES 475
Scope; The field of industry; Accounting problems; Industrial
characteristics; Nature of the industry; Income statements; Bal-
CONTENTS
CHAPTER PAGE
26. INDUSTRIAL SECURITIES (Continued)
ance sheets; Analysis of industrial statements; Industrial bonds;
Preferred stocks; Common stocks; Securities analysis; Industrial
reorganizations.
27. BANK STOCKS 517
Scope; Classification of banks; Banking functions; Non-financial
considerations; Types of statements and financial information;
Income statements; Balance sheets; Bank stock analysis; Stock
values, prices, and yields; Investment position of bank stocks.
28. STOCKS OF FIRE INSURANCE COMPANIES . . 534
Scope; Scope of the industry; Functions and characteristics of
fire insurance companies; Investment policy of fire insurance
companies; Income statement; Balance sheets; Fire insurance
statement analysis; Stock values, prices, dividends, and yields;
The market for insurance company stock.
29. INVESTMENT COMPANY SECURITIES .... 548
Scope; Nature of the investment company; General purposes and
advantages; Types of investment companies; Scope of the group;
European background and early American history; Later experi-
ence; Regulation; Fixed trusts and other lesser forms; Finan-
cial statements; Capitalization and leverage; Organization, man-
agement, and supervision; Distribution and redemption of shares;
Purchase and sale commissions; Investment policy; Measures of
performance and selection; Senior securities and warrants; Spe-
cial uses of investment company shares; Tax status of investment
companies; Prices, dividends, and yields; Conclusions.
30. REAL ESTATE AND REAL ESTATE OBLIGATIONS . 582
Scope; Classification of types of real estate investments; The
appeal of real estate investments; Real estate held for income;
Advantages of investment in income property; Home ownership;
Real estate mortgagesgeneral characteristics; Residential
mortgages; FHA-insured mortgages; VA-insured and guaranteed
loans; "Conventional" home mortgage loans; Institutional sources
of residential mortgage credit; Home mortgages as investments
for individuals; Government agencies involved in home financ-
ing; Commercial and industrial mortgages; Farm mortgages;
Real estate bonds.
SELECTED REFERENCE LIST . , 606
INDEX
625
PART I
INTRODUCTION
CHAPTER 1
THE NATURE OF INVESTMENT
Scope. The purpose of this chapter is to discuss the economic
and financial background of investments and to provide an intro-
duction to the detailed study of investment programs and invest-
ment media. The order of discussion is: (1) economic and financial
aspects of investment, (2) investment versus speculation, (3) the
supply of new capital, (4) the demand for new capital, (5) the re-
turn on investments, (6) scope of the book.
Economic and financial aspects of investment. Investment may
be defined as the productive employment of capital. In the eco-
nomic sense, it involves the direction of savings or accumulated
wealth into productive uses which fill an economic need and which
are expected to produce a return. In the narrower traditional sense,
such uses would be restricted to "capital goods," that is, goods used
in the production of other goods. In the broader sense, the use of
funds by government to produce benefits of a social nature must
be included, as well as the business use of funds that, in addition to
increasing current assets and plant capacity, may also build up
good will.
From the point of view of the investors or suppliers of capital,
investment is the commitment of present funds for the purpose of
deriving a future income, regardless of whether the funds are de-
voted to a "productive" use in the economic sense. Thus, the pur-
chase of a government bond whose proceeds are devoted to war
purposes is just as much an investment as is the purchase of a cor-
porate bond whose principal is invested in additional plant ca-
pacity. Deficit borrowing by governmental bodies is rarely for
productive purposes, yet government bonds rank high as in-
vestments because investors usually receive interest payments
promptly when they are due. Present funds are exchanged for
future funds, and the purchase of the right to future funds (or the
4 THE NATURE OF INVESTMENT
hope of them) is an investment from the individual point of view.
Investment versus speculation. The line of demarcation between
investment and speculation is difficult to draw because of the
loose manner in which the terms are used. The difference is more
in degree than in kind. In the traditional sense, the distinction is
on the basis of the degree of risk assumed: speculation involves
the purchase of high-risk securities or other media, whereas invest-
ment involves the acquisition of low-risk media whose future
income is relatively certain. The difficulty with this distinction is
that all commitments for future funds involve the assumption of
risk, because the production of future funds depends on conditions
that cannot be accurately foreseen. Risk is a matter of degree,
and the line between low-risk and high-risk is often purely arbi-
trary. If all investment securities could be ranked in order of risk,
from a short-term Federal obligation to the weakest common
stock, where would the line between investment and speculation
be drawn?
Another common distinction between investment and specula-
tion is derived from the above, namely, that investment, to insure
safety, must be represented by a contract by a responsible debtor
to repay the original money outlay at a definite date with a definite
return in the meantime. For many years stocks as a class were
excluded from the investment category because they represented
ownership and not a contract to repay a definite sum. The assump-
tion was that, because of their basic character, such instruments
would involve such inherent risk as to place them beyond the pale
of investment thinking. Certainly the record of stocks as a class is
not as strong as that of bonds; yet there are high-risk bonds that
are virtually worthless and stocks that have an eminently respect-
able record over the years. It would seem illogical to dignify
a poorly secured bond as an investment and ignore a strongly
entrenched stock merely because it represents ownership and
hence has possibilities of loss (and of profit).
Another distinction between the two terms is frequently drawn
on the basis of the period for which the commitment is made. The
speculator is said to be interested in the quick turn, the investor
in long-run holding. Again, there is an element of validity in this
position. But many corporations and individuals make short-term
commitments that afford a high degree of protection, and many
"speculators" are prepared to hold on for a long period in the hope
that very material gains will be made over the years.
Another distinction is found in the motive of the supplier of
funds. The investor is said to be interested in income; the specu-
lator, in capital appreciation. The difficulty with this concept is
that it would exclude from investment the ownership of securities
which yield little or no current return but which represent a
steady growth through reinvestment and an increase in principal
value and eventual payment of substantial size. It would include
in investment the ownership of securities of very high risk which
are currently yielding a very high income that is subject to sudden
shrinkage or even disappearance.
Analysis of the customary distinctions between the two con-
cepts reveals that it is difficult, if not impossible, to draw an exact
line of demarcation. There are extremes, of course, that would be
agreed on by nearly everyonesituations that would universally
qualify either as investment or as speculation. A much more fruit-
ful approach is to relate the amount and form of the financial
commitment to needs, purposes, and goals of the investor. Some
can take little or no risk and must be content with a very modest
return; others can assume considerable risk and can base their
plans on the possibility of a high return. Some investors must con-
centrate on high-grade bonds and other relatively safe commit-
ments in order to assure the income that their plans require; others
can logically include equities in their plans, provided that the
selection, timing, pricing, and diversification of such holdings are
adequately handled. Some investors can reasonably acquire short-
term holdings at little or possibly large risk while others must
frame a long-range program that minimizes risk, emphasizes in-
come, and relies on little or no capital appreciation.
There is an old saying that a good investment is a successful
speculation. This suggests that it is the end result that determines
the distinction. Such a concept is useful in that it suggests that
risk is a matter of degree and that some degree of risk is inevit-
able. The concept is dangerous, however, in that it suggests that
intelligent planning and selection may not be worth while. There
is a very wide range of securities and other media to fit a wide
range of investment goals. The problem of investment is to relate
the media and the goals in an intelligent fashion.
Notwithstanding the broad concept of investment implied in
the foregoing discussion, this volume will exclude those operations
that are designed primarily to take advantage of rapid changes in
the market values of securities. There is a multitude of discussions
and technical services devoted almost entirely to the analysis of
short-term market swings and trends that may be of interest to
many investors. But the questionable results of such operations,
and the danger of substituting interest in spectacular price
changes for the more important long-range investment goals sug-
gest that a greater service would be performed by concentrating
on those operations traditionally associated with investment and
by avoiding those traditionally associated with speculation and
gambling.
The supply of new capital. New capital is created in any com-
munity which produces more than it consumes. The individuals
and institutions that possess this surplus naturally desire to put
it to productive use. Their decision to postpone immediate con-
sumption arises out of a time preference or a savings incentive.
In the former case, they believe that their surplus will be more
valuable to them at a future time, as evidenced in purchasing a
deferred annuity or in making a pension contribution. In the latter
case, they are motivated by a more immediate incentive, such as
the regular receipt of an attractive interest payment. In either
event, their savings become available to users either directly
through the transfer of securities or indirectly through the finan-
cial institutions where the savings are held.
While some new capital would always be available to indi-
vidual, corporate, or government users even at negligible interest
rates, the promise of a favorable rate of return acts as a powerful
stimulant to savings. But even at the low interest rates available to
savers in recent years, the volume of funds available for invest-
ment has grown enormously. The supply of new capital is de-
pendent on that portion of the national income that is saved.
World War II and post-war years saw a tremendous growth in
savings both in absolute and in relative terms. In contrast to the
glamorous year of 1929, when savings were $3.7 billions or 4.4 per
cent of personal income, the figure reached a total of $9.8 billions
or 10.3 per cent in 1941, and a peak of $35.6 billions or 21.6 per
cent of personal income in 1944. After this year, savings declined
considerably (to $11.9 billions or 5.3 per cent of personal income
in 1950). The result was an accumulation of funds in the hands
of individuals that had an impressive effect on yields in the bond
market, both directly and through savings institutions, and be-
latedly on the stock market.
Evidence of the accumulation of individuals' savings is found
in the growth of institutions that are devoted primarily to the
assembly of such savings. In the years 1941 through 1950, deposits
in the Postal Savings system grew from $1.3 to $2.9 billions. Dur-
ing the same ten-year period, time deposits of all banks in the
United States increased from $26.5 to $56.5 billions; assets of life
insurance companies grew from $17.5 to $63.7 billions; assets of
savings and loan associations rose from $8.7 to $16.9 billions. The
tremendous accumulation of funds in savings institutions put
great pressure on the bond market and has been responsible in
part for the continuation of low interest rates. During the same
ten-year period, United States Savings Bonds outstanding grew
from $4.3 billions to $58.0 billions, indicating a diversion of a
substantial portion of savings from the regular capital market. The
growth of Savings Bonds outstanding halted in 1951.
Another important source of savings is represented by business
funds available for reinvestment or expansion. In 1941, corpora-
tion depreciation allowances and undistributed profits amounted
to $11.4 billions; the figure reached its peak of $19.5 billions in
1950.
The productive employment of capital. Capital flowing from
investors and investment institutions to corporate and public
borrowers is used to accomplish many different purposes. The
more important of these functions are:
(1) To finance a new enterprise. Promoters of new enterprises
usually need capital in excess of their personal funds. In a period
of high taxes, prices, and wages, the difficulties of initiating a
profitable new enterprise are manifest.
(2) To finance the expansion of an established enterprise. Many
established enterprises need outside capital for the purchase
of additional buildings and equipment and for working capital
purposes.
(3) To finance the betterment of existing facilities. It is fre-
quently advisable for industries to seek new capital in order to
replace obsolete equipment and thereby reduce costs and lower
sales prices.
(4) To finance public improvements. Governmental bodies
customarily borrow money in order to spread the cost of perma-
nent improvements over long periods.
(5) To finance public expenditures. During periods of low tax
revenues or of high expenditures, governmental bodies borrow
money in order to cover deficits in fiscal budgets.
(6) To finance foreign trade. Exports to nations which are not
offset by equivalent imports are customarily settled by promises
to make future payment, which promises are in turn offered to
investors. The tremendous wartime outlays by the Government
for "lend-lease" to allied nations are continuing in the form of
foreign aid for both relief and economic recovery. These outlays
are almost entirely Government-financed.
(7) To finance private consumption. Companies which make
personal loans and which discount installment purchase contracts
require new capital to meet larger demands for their services.
The demand for new capital. The demand for new capital
comes from the productive enterprises of the nation which desire
funds for expansion or replacement purposes such as those out-
lined above. Although many corporations have relied on their
own internal sources for much of their capital needs in the post-
war period, many others, and virtually all governmental bodies,
must seek outside capital.
During the period 1941-1950, the most important single in-
fluence on the demand side (or supply of investments) was, of
course, the growth of the Federal debt from $45 billions at the
end of 1941 to the peak of $278 billions early in 1946. Subsequent
years saw a modest reduction, but the recent reappearance of
international crises threatens to push the debt beyond the pre-
vious record level. In addition to Federal debt, the annual amount
of state, municipal, and corporation securities issued for new
capital (as contrasted with refinancing) rose from $2.9 billions
in 1941 to a peak of $9 billions in 1948; 1949 and 1950 saw a de-
cline from this peak to $8.3 billions in the latter year.
The return on investments. But even the tremendous increase
in public and private financing in the post-War period failed to
absorb the funds available for investment, at least insofar as bonds
THE NATURE OF INVESTMENT 9
are concerned. Until the spring of 1951, the pegging by Federal
fiscal agencies of the rate on long-term Treasury bonds at 2.5 per
cent discouraged the appearance of rising interest rates, and the
pressure of funds for bond investment forced the rate on Treas-
ury's to as low as 2.3 per cent in 1950 and the yield on highest-
grade corporation bonds to as low as 2.6 per cent. In 1951 these
rates rose to 2.7 and 3.0 per cent, respectively. Such low yields
present a real problem to institutional and individual investors
seeking safety during a period of rising prices.
In contrast to the low yields on bonds, dividend yields on cor-
poration stocks became very generous in post-War years, as in-
dicated by the following comparison of yield on high-grade cor-
porate bonds (Moody's Aaa series) and common stocks (Moody's
200 common stock series):
Corporate Bonds Common Stocks
1941 2.77% 6.25%
1942 2.83 6.67
1943 2.73 4.89
1944 2.72 4.81
1945 2.62 4.19
1946 2.53 3.97
1947 2.61 5.13
1948 2.82 5.78
1949 2.66 6.63
1950 2.62 6.27
This spread was maintained in spite of certain forces that
tended to lessen the supply of stocks available for investment.1
Corporations have not fed the market with new stock issues in
substantial volume. In 1950, for example, about 60 per cent of
corporate funds for both working capital and plant requirements
was derived from retained profits and depreciation allowances,
and only about 5 per cent from new stock issues. In addition to
the dearth of new stock issues, those outstanding have tended to
drift to an increasing degree into lodgings where they are at
least temporarily impoundedinto investment company port-
folios, trust and endowment funds, and, to a certain extent, pen-
sion funds. But in spite of these special influences on the supply
of corporate stocks, they have continued to evaluate earnings and
1 Bond yields rose in 1951 following the "unpegging" of the support price of
United States long-term issues in that year, but the spread between yields on bonds
and stocks was substantially maintained.
10
dividends at very generous rates, reflecting a hesitancy to take
risk that ill befits a growing and vigorous economy.
The continued spread between the yields on high-grade bonds
and similar media of investments and on common stocks has
aroused interest in the latter on the part of many investors who
have been traditionally bond-minded. But the choice between
bonds and stocks, or between any media of investments, cannot
be considered apart from the special needs of the individual in-
vestment situation.
Scope of the book. The person who has savings to invest and
who desires to act intelligently and prudently faces many prob-
lems that require careful consideration. The first of these is the
determination of the goals or purposes toward which savings will
be directed, and the planning of a logical program that will fulfil
these aims. Such planning involves decisions concerning the forms
that investment should take. The investor must be acquainted
with the alternative types of investment media that are available,
along with the forces that play on each type. Chapters 2 through
6 (Part II) are designed to outline these alternatives in general
and to describe in particular savings institutions and corporation
securities, the media that present the most complexities.
Equally important are decisions concerning the timing and
continued management of a portfolio. Chapters 7 through 11
(Part III) suggest certain approaches that may be helpful in
this regard, both for individuals and for institutions.
The next general step in investment planning, once the goals
and the general media have been determined, is the analysis and
selection of specific investment situations. The whole of Part V
of this book is devoted to a discussion of this problem insofar as
securities are concerned. In order to fulfil their aims, most in-
vestors need the greater safety contributed by diversification
among various types of investments. But the investor of limited
means finds such diversification difficult if not impossible, if at-
tempted directly, and so the possibilities of indirect investment
through investing institutions becomes an important question.
Methods of selection and analysis of such institutions are likewise
discussed in Part V.
As aids to investment planning and management, the investor
should be acquainted with the various sources of investment in-
11
formation and should know how to follow investment news and
developments intelligently. Sources of investment information
are described in Chapter 12, and aids to the intelligent reading of
investment news are suggested in Chapter 13.
The procedures by which investmentsin particular, corporate
securitiesoriginate and the operations of the securities markets
are important segments of investment knowledge without which
the investor is in danger of acting with ignorance concerning
financial institutions and the investment mechanism. These mat-
ters are described in Chapters 14 and 15, while Chapter 16 is
designed to acquaint the reader with the procedures through
which his actual securities orders are effected.
All investors must be acquainted with the basic mathematical
language used in investment calculations. Particularly important
is the concept of investment yield, or rate of return expressed
as a percentage of the capital investment, which, in the opinion
of the market at the time, reflects the degree of risk in any given
investment situation. The basic concepts of investment mathe-
matics form the subject matter of Chapter 17.
To an increasing extent tax considerations are entering into
the matter of investment planning and selection, and this situa-
tion promises to persist for many years to come. So important are
tax matters that they have been singled out for special attention
in Chapter 18 and are also referred to elsewhere wherever im-
portant.
(6)
(5)
(4)
(4)
(3)
(2)
PART II
BONDS
STOCKS
SAVINGS
SECURITIES
DEPOSIT TYPES
CLASSIFICATION
LIFE INSURANCE
SAVINGS BONDS
GENERAL CLASSES
INVESTMENT MEDIA
CHAPTER 2
TYPES OF INVESTMENTS:
GENERAL CLASSIFICATIONS
Scope. The purpose of this chapter is to outline the various
types of investment media that are available to satisfy the re-
quirements of a wide range of investment goals, and to classify
the media according to important investment characteristics.
Many investors are not aware of the rather remarkable range of
investment forms. Yet no investment program can be worked out
satisfactorily unless the investor has familiarized himself with
the various alternatives.
No attempt is made in this chapter to discuss the investment
merits of the media that are classified, nor the types of investors
for which the media would be most suitable. Such material is
reserved for later discussion. The order of topics is indicated by
the accompanying classification.
CLASSIFICATION OF INVESTMENT MEDIA
A. Classification by general form
1. Savings group
a. Postal Savings deposits
b. Savings deposits in commercial banks
c. Deposits in mutual savings banks
d. Accounts in savings and loan associations
e. Life insurance and annuity contracts
f. United States Savings Bonds
2. Securities group
a. Government securities
(1) Federal
(2) State
(3) Municipal
(4) Foreign
b. Securities of business corporations
(1) Bonds; stocks
15
16
TYPES OF INVESTMENTS
(2) Industrials, public utilities, railroads
(3) Other classifications
c. Securities of financial companies
(1) Commercial bank stock
(2) Insurance company stock
(3) Investment company securities
d. Real estate securities
(1) Mortgages
(2) Bonds
3. Real estate proper
a. For occupancy
b. For income
4. Business group
B. Other classifications
1. By investor status
2. By security
3. By maturity features
4. By degree of marketability
5. By tax status
6. By degree of management required
7. By degree of risk
8. By degree of protection against price changes
Classification by general type or group. Investment media can
be classified according to their general form. The very form in
which funds are committed in some instances encourages, and in
other cases discourages, the selection of a type. Some are simple
and direct; others present more complex problems of analysis and
investigation. Some are familiar to all investors, while others are
rarely included in the investment thinking of many individuals.
Some are more appropriate for one type of investor than for an-
other.
1. Savings group. This group includes the claims that investors
have on institutions that provide hquidity, modest income, and
(under ideal circumstances) little or no risk of loss of dollar
amount of principal. Six major investment media belong in this
group: Postal Savings deposits, savings deposits in commercial
banks, deposits in mutual savings banks, accounts in savings and
loan associations, life insurance and annuity contracts, and United
States Savings Bonds. Demand deposits in commercial banks
yield no income and are excluded from the investment category,
although they are of course involved in any over-all investment
17
program from the standpoint of liquidity and availability of funds
for investment in securities and other types of media.
The first four of these media (discussed in Chapter 3) might be
described as deposit or banking-type investments held primarily
for liquidity but producing some income. Reserves in life insur-
ance companies also represent savings, provide liquidity in times
of emergency through their cash-surrender values, and are built
up at a modest rate of interest. Although the primary function of
the life insurance companies is to serve as insurers of risk rather
than as depositories as such, most insurance contracts combine
both savings and risk protection. It seems best, therefore, to in-
clude the investment aspects of life insurance in the discussion
of the banking-type institutions.
Many discussions of "investments" omit life insurance. Yet life
insurance should be an integral part of most investment programs.
It does not present the complexities of investment in securities
and falls into the investment category in only a limited sense. But
to ignore it in the treatment of the subject of investments would
be to ignore the type that should have top priority in most finan-
cial plans. Insurance is the only means by which most investors
can provide a substantial estate for dependents. And some types
of life insurance contracts contain a significant savings or invest-
ment element that is available during the life of the insured. These
aspects of life insurance, and the means by which provision for
old age may be made through annuities, are discussed in Chap-
ter 4.
The United States Savings Bond has become the most important
single type of savings medium. The amount outstanding exceeds
the total time deposits of all banks in the United States. While
the savings bond is a claim against the Federal government as
opposed to a private organization, and while it differs in several
respects from the type of claim represented by a bank deposit,
its similarity to the deposit-type investment with respect to li-
quidity, safety, and modest rate of income justify its classification
in the savings-institution category. Savings bonds are discussed
in Chapter 4.
2. Securities group. Many thousands of securities of all kinds
are available to the investor. These may be classified in a large
18
number of ways. The following classification is based on type of
issuer. No attempt is made to discuss their investment qualifica-
tions at this point. The leading groups receive extensive treatment
elsewhere in this book.
a. Government securities. From the standpoint of volume, gov-
ernment securities take first place in the investment scene. Their
vast importance to individual and institutional investors can
scarcely be overemphasized. In addition to all banks, all insurance
companies, many thousands of trust estates, endowment funds,
business corporations, government agencies, and investing con-
cerns, many millions of individuals own government securities.
At the end of 1950, individuals held over $66 billions of Federal
obligations alone.
Four classes of government securities are discussed later in this
volume (in Chapters 19-22): (1) direct and guaranteed debt of
the United States; (2) bonds of states; (3) obligations of political
subdivisions, or municipal bonds; (4) bonds of foreign govern-
ments. The first group, exceeding $250 billions, can be subdivided
in several ways: by maturity, by tax status, by ownership, by
marketability, by purpose of issue, and by other characteristics.
State and municipal bonds are likewise divisible into various cate-
gories. Foreign securities include issues of corporations and gov-
ernments; the latter are emphasized in this volume. The interest
of American investors in foreign bonds diminished greatly after
the disastrous experience with such bonds in the 1930's. Direct
private investment and Federal government aid in various forms
have almost entirely replaced private purchase of foreign bonds
as the means by which American capital is going abroad. Never-
theless, there is still a substantial volume of foreign debt held in
this country.
b. Securities of business corporations. These are of two general
types: bonds and notes, and stocks. (Corporate notes, represent-
ing debt of intermediate maturity, are in effect shorter-term
bonds.) A classification that is widely used in investment circles
involves a threefold division into: (1) industrials, including manu-
facturing, merchandising, service, and extractive concerns; (2)
public utilities, including holding and operating companies in
electric light and power, gas, telephone, telegraph, water, traction
and electric railway, and miscellaneous; (3) steam railroads. Each
19
of these main groups can be further subdivided. In the industrials
group especially, a large number of subclassifications is used in
the investment services.
Other useful methods of classifying business corporation se-
curities are: (1) by legal status of ownerhere we find two general
classes: bonds (and corporate notes) and stocks; (2) by type of
pledge or lien, if anythere is a variety of secured instruments,
chiefly types of secured bonds, and two general classes of un-
secured instruments, debenture bonds and stocks; (3) by purpose
of issuesome corporate securities are issued for specific purposes
and others are used to finance general working capital and capital
expansion needs; (4) by degree of participation in earnings, that
is, whether they bear a fixed or an uncertain incomemost bonds
and preferred stock bear a fixed rate of return, although there are
some types that offer the possibility of a higher income, while
common stock has no fixed rate, receiving the net income, large
or small, that may be distributed as dividends at the discretion of
directors; (5) by maturity and redemption features. Stocks, both
preferred and common, have no maturity date, since they involve
no promise to pay principal. However, the call feature in preferred
stock, and to a certain extent its fixed liquidating value, are char-
acteristics that limit the amount of any payment of capital to
their holders under certain conditions. Bonds, with very few
exceptions, have a definite maturity date and usually include
provisions for redemption before maturity at the option of the
corporation.
The classifications set forth above are suggestive of many that
may be used in studying and comparing corporate securities.
Others will be indicated in later chapters. Chapters 5 and 6 are
devoted to a more detailed description of the characteristics of
bonds and stocks, and certain general conclusions are reached
concerning their investment merits. The procedure for the analy-
sis of individual industrial, utility, and railroad securities com-
prises the content of Chapters 23-26.
c. Securities of financial companies. The securities issued bv
three main types of private financial institutions play an important
part in the investment programs of many individuals: shares in
commercial banks; shares in insurance companies, especially
fire and casualty companies; and debentures, preferred stock, and
20
common shares of investment companies. These institutions pro-
vide the means by which the investor can make an indirect com-
mitment in a portfolio of securities and other instruments. Their
operations are highly specialized and the analysis of their securi-
ties requires special attention apart from that of corporate se-
curities in general. The investment characteristics and methods
of analysis of securities of the financial group provide the subject
matter of Chapters 27 to 29.
d. Real estate mortgages and bonds. Obligations secured by
real estate hold an impressive place in investment portfolios, es-
pecially of financial institutions. Their specialized character and
the special factors that must be considered in their analysis justify
special treatment of these instruments apart from corporate se-
curities in general. Discussion of real estate securities is found
in Chapter 30.
3. Real estate proper. In addition to the ownership of real estate
mortgages and bonds, direct investment in real estate proper
plays an important role in many investment programs. The most
important form of such investment is the ownership of domestic
property for occupancy. The most significant single investment
that most families make is in a home. The investment aspects of
home ownership are not the only ones that must be taken into
consideration by the homeowner or the potential homeowner, but
they are too often overlooked or given scant attention. Considera-
tion is given in Chapter 30 to the investment factors in the owner-
ship of real estate both for income and for occupancy.
4. Business group. The savings of many thousands of individuals
are directed toward the purchase or expansion of the businesses
they own. Especially in smaller concerns, proprietors and partners
often commit the bulk of their savings to a business venture.
But discussion of this type of investment would involve a dis-
cussion of business operation and management itself. Further-
more, funds invested in one's own business are not subject to
rapid recovery in the marketplace. For these reasons no attempt is
made in this volume to consider what to many people is the most
important single investment of all.
Other classifications. In addition to the above classifications by
general type, a variety of other groupings of investments is pos-
sible. The following are suggestive:
21
1. By investor status. The investor is a creditor when he holds
corporate and government bonds, has a savings account in a bank
or other institution, owns a mortgage, or has a life insurance or
annuity contract. For the most part these might be called "fixed-
income obligations." He is an owner of so-called "equities" when
he owns preferred and common stocks or real estate or has a
share in a business. (Preferred stock belongs in the ownership
category, but most investors in this type of security place it, for
better or for worse, in the fixed-income category because of its
usually limited return and fixed liquidating value.)
2. By security. All equities are unsecured. Some debt instru-
ments, such as debenture bonds of corporations, and all direct
obligations of Federal, state, and municipal governments are
technically unsecured in that they have no lien on specific assets,
but represent general promises to pay and so are secured by gen-
eral assets and earnings. The lack of specific security does not
necessarily represent a weakness. Some of the strongest corporate
obligations, together with government bonds, receive the highest
rating even though "unsecured." Deposits, and claims against in-
surance companies, are likewise "unsecured."
3. By maturity features. All equities lack a maturity date be-
cause they do not represent promises to pay. As noted previously,
however, preferred stocks have certain features that give them a
semblance of maturity, especially the call or redemption feature
that makes them mature at the option of the corporation. Shares
in investment companies of the open-end or mutual type represent
equity, but are redeemable on demand. This gives them maturity
of a sort but not a fixed value. Perhaps it would be better to say
that they enjoy liquidity rather than a definite maturity. Debt
instruments, with rare exceptions, mature at a specified time
or at optional dates, as in the case of Treasury bonds. Life in-
surance contracts and annuities mature at death or retirement age.
4. By degree of marketability. Investments differ considerably
with respect to marketabilitya factor that is of considerable
significance to many investors. Listed securities and those traded
actively over-the-counter enjoy superior marketability. But many
bonds and stocks have no ready market. Deposit-type investments
enjoy marketability in the sense that they are liquidcash is
readily transferable. One disadvantage of mortgages and of real
22
estate is a relative lack of marketability, especially in depressed
markets. The benefits of insurance and annuity contracts are
transferable only under limited conditions, although the cash-
surrender value of an insurance policy is available on demand.
The need of marketability varies greatly from investor to in-
vestor. It is often most essential, and income may have to be
sacrificed to obtain it.
5. By tax status. The tax status of investments becomes more
important as the rates of income and estate taxes increase and as
the investor gets into higher tax brackets. The search for total
or partial exemption plays an important part in the planning of
many investors and has a significant effect on the prices and
yields of certain securities. The tax status of securities is discussed
in Chapter 18.
6. By degree of management required. Investors differ in the
extent to which they are willing and able to assume the respon-
sibility of managing their investment commitments. The appeal of
different types of investments is therefore affected by their rela-
tive freedom from care. Three factors determine whether or not
the investor need spend little or much time and effort in selecting
and managing his investments: (1) the relative safety of the
investment; (2) the degree to which the problems of management
are turned over to others; and (3) whether or not the investment
is of a highly specialized character. United States Savings Bonds
are care-free because they are simple and straightforward. An
annuity is care-free because of its relative safety and because
the insurance company assumes the problems of portfolio man-
agement. Real estate lacks the care-free quality because it has
many factors that need constant attention and special training
and experience.
7. By degree of risk. Classification by degree of risk can be in-
complete at best. With the possible exception of United States
Savings Bonds and Postal Savings deposits, risk of loss of dollars
of income and principal is found in all investments. Even Treas-
ury bonds rise and fall in market value. Deposits in insured banks
and savings and loan associations may approach being riskless
insofar as principal is concerned, but the income derived from
deposited savings can and does vary with the times. Life insur-
ance companies "guarantee" a rate at which their reserves are
23
built up, and the strong companies have a remarkable record. The
degree of risk in corporate securities runs the whole gamut from
very high-grade short-term bonds to worthless stocks. Bonds as
a group have a stronger record than stocks as a group. Yet each
group contains a wide range in respect to quality. And industries .
and companies have a way of changing in investment merit.
8. By degree of protection against price changes. All invest-
ments that involve promises to pay income, principal, or both in
a fixed number of dollars are vulnerable to the changes in the
purchasing power of the dollar. Only "equities," and debt se-
curities that are low-grade or that have participation or convert-
ible clauses, offer any hope of a hedge against the rise in the price
level, and these only imperfectly or in varying degrees. One of
the tragedies associated with savings and investment is that the
greater the need for a "hedge against inflation," the less able the
investor is to afford such a hedge. The assurance of dollars of in-
come and principal is so important to the investor of limited
means that the risks involved in holding most equities should not
be undertaken.
Common stocks, shares of investing institutions such as fire
insurance companies and investment trusts that hold portfolios
of common stocks, and weak and speculative bonds and preferred
stocks offer possibilities of appreciation and of increased income
as prices rise and so may protect the buying value of the investor's
funds and income, at least to a certain extent. This factor is very
important whenever the investment fund is designed to provide
an income for living purposes. It constitutes a strong appeal for
including securities of these types, along with fixed-income obli-
gations, in many investment portfolios.
Summary. The investor's problem is to select (or have some-
one select for him) appropriate securities that (1) fit his needs
and (2) reflect the degree of risk that he can afford to assume,
with the hope that income will be commensurate with that risk.
Many investors do not realize that there are many general types
and literally thousands of individual outlets for the placement of
their savings. To some the term "investments" means only se-
curities, possibly only common stocks; others work out a care-
fully balanced program that utilizes many of the various groups
and different individual selections within those groups.
24
Because corporation securities present the most problems of
selection and analysis, the bulk of this volume is devoted to them.
Chapters 5 and 6 contain a discussion of their general character-
istics. Much of the latter portion of the volume is devoted to their
analysis.
CHAPTER 3
SAVINGS INSTITUTIONS AND
SAVINGS BONDS
Scope. The purpose of this chapter and of Chapter 4 is to dis-
cuss the investment aspects of claims against the various institu-
tions that hold the savings of individuals, provide a modest return
on those savings, and stand ready to provide cash on demand or
on short notice. The order of discussion in Chapter 3 is: (1) Postal
Savings deposits, (2) time deposits in commercial banks, (3) de-
posits in mutual savings banks, (4) accounts in savings and loan
associations. Chapter 4 covers (5) United States Savings Bonds,
and (6) life insurance and annuity contracts. The first four of
these are "deposit-type" investments. United States Savings Bonds
differ from deposits in form, in character of the debtor, and in
several other respects. But the motives lying behind their pur-
chase and the investment requirements that they are designed
to fulfil are similar to those that pertain to the deposit-type
group.
Discussion of the investment aspects of life insurance and an-
nuities in chapters primarily devoted to savings institutions proper
requires some explanation. Perhaps the chief justification of the
arrangement lies in the fact that life insurance companies in
effect accept savings in the form of premiums, and that most life
insurance contracts contain an important savings element.
The growth of savings. The tremendous accumulation of sav-
ings in the United States is indicated by the increase over the
years in the accounts reflecting such savings. The following year-
end figures are indicative of the trend (in billions of dollars): 1
1 Sources: Federal Reserve Bulletin; Department of Commerce, Bureau of the
Census, Statistical Abstract of the United States; Housing and Home Finance
Agency, Housing Statistics.
25
26
SAVINGS INSTITUTIONS
Time deposits, all commercial
1930
1935
1940
1945
1950
Life insurance companies (net
$19.0
$13.2
$15.8
$30.2
$36.5
reserves and accumulated
dividends)
13.7
17.2
24.7
37.5
54.0 (est.)
Mutual savings banks deposits
9.4
9.8
10.6
15.3
20.0
Postal Savings deposits
.3
1.2
1.3
3.0
2.9
Savings and loan associations-
accounts and certificates ....
6.3
4.3
4.3
7.4
14.0
U. S. Savings Bonds outstanding
(redemption value)
.2
2.8
44.2
58.0
1. Postal Savings Deposits
The Postal Savings System was set up in 1911 for the purposes
of encouraging thrift and of providing a safe depository for sav-
ings. The amount of deposits was very small until banks came
into disfavor in the early 1930's. Since then the System has con-
tinued to attract a considerable volume of funds, especially during
World War II, when the 2 per cent rate of interest became rela-
tively attractive. Probably a much larger volume that would have
been deposited has gone into Savings Bonds in recent years. And
the advent of insurance of bank deposits has also restricted the
appeal of the Postal System.
Deposits with the System are very similar to bank deposits,
except that the United States Government is the creditor. Only
individuals may open accounts. Deposits are evidenced by certi-
ficates issued in denominations of from $1 to $500. A limit of
$2,500 per account is imposed. Withdrawals may be made on de-
mand.
The rate of interest (2 per cent, or less in states placing a lower
limit on state bank accounts, as in New Jersey and Mississippi)
is currently no higher than that obtainable on bank savings de-
posits. The appeal of the Savings System account is one of safety
and liquidity rather than income. One disadvantage is that in-
terest does not compound annually, but must be redeposited by
SAVINGS BONDS
27
2. Time Deposits in Commercial Banks
About 17,000 of the 19,000 banking offices in the United States
furnish savings facilities. Time deposits, of which the bulk are of
the savings type, are defined as those not subject to check and on
which the bank may require 30 days' notice of intention of with-
drawal. Unlike checking accounts, which bear no interest and
enter into investment planning only insofar as immediatelv avail-
able cash is important, savings accounts in commercial banks may
legitimately be classed as investment media. They bear interest
at very modest ratesfrom 1 to 2 per centand immediate liquid-
ity is obtained, for although the bank has the right to demand
notice of withdrawal, such right is rarely exercised. In some states
the assets of the savings department must be segregated from the
other assets of the bank. The state authorities restrict the amount
and type of loans permitted and issue an approved list of securi-
ties in which savings funds may be invested. There is no such
specific segregation in the case of national banks.
The interest rates paid on savings deposits are subject to the
over-all regulation of the Board of Governors of the Federal Re-
serve System, insofar as member banks are concerned. At the
present time the maximum interest rate is set at 2/2 per cent. The
rate payable by a member bank may not in any event exceed the
maximum rate payable by state banks on like deposits under the
laws of the state in which the member bank is located. In very
recent years, the competition for funds among banks has been
working to the advantage of the saver, for interest rates on savings
accounts have shown a material increase. By 1951 some banks had
raised their rates to as high as 2 per cent. But in general the rates
paid by commercial banks average about Vk per cent and are the
lowest among the institutions competing for funds (commercial
banks, mutual savings banks, and savings and loan associations).
This is so because time deposits in commercial banks are in effect
demand deposits, and because they must maintain liquidity, the
commercial banks do not earn as much on their thrift accounts.
All national and most state banks are members of the Federal
Deposit Insurance Corporation, which insures individual accounts
up to $10,000. For this reason most depositors in insured banks
need not be concerned about the safety of their funds. They have
28
liquid assets drawing a small rate of return. But the rate is so
modest that savings accounts are considered primarily as reserve
funds rather than sources of income.
The relative importance of time deposits in various categories
of banks is indicated by the following classification as of Decem-
ber 31, 1950 (dollar amounts in billions): 2
Insured banks:
4,958
33.8%
1,912
13.1
Insured non-member commer-
6,562
44.8
Insured mutual savings banks
194
1.3
13,626
93.0
Non-insured banks:
Non-member commercial
banks
Non-insured mutual savings
banks
Total non-insured
All banks
Banks
Number Per Cent
689 4.7
335 2.3
1,024 7.0
14,650 100.0%
Time Deposits
Amount Per Cent
$19.9 35.2$
9.4 16.6
6.7 11.9
14.3 25.3
50.3 89.0
.5 1.0
5.7 10.0
6.2 11.0
$56.5 100.0%
As of December 31, 1950, 93.2 per cent of all banks of deposit
were insured. These banks held 95.3 per cent of all deposits. The
increase in insurance per account to $10,000 in September, 1950,
brought the proportion of all fully protected accounts in insured
banks to nearly 99 per cent.3
In summary, the savings account in a commercial bank offers
the advantages of safety, liquidity, convenience, and modest in-
come. No tax advantages are enjoyed, as interest on accounts is
fully taxable. The chief usefulness of the savings account to the
investor is as a means of holding a cash reserve and of accumulat-
ing funds for later investment in other types of media.
3. Deposits in Mutual Savings Banks
Importance of the group. The 529 mutual savings banks are
chartered in 17 states, primarily in the New England and Middle
Atlantic States. Seventy-five per cent of the banks are located in
2 Source: Federal Reserve Bulletin.
3 Annual Report of the Federal Deposit Insurance Corporation, 1950, pp. 4-9.
SAVINGS BONDS
29
New York, Massachusetts, and Connecticut, and in these three
states 80 per cent of savings deposits are located. There are only
12 banks in the middle west and 4 on the Pacific coast (in Wash-
ington and Oregon). Such institutions appeal especially to the
small investor who requires a maximum of safety and who is not in
a position to select his own investments. As explained in a later
chapter, savings banks are permitted to invest their deposits
solely in those securities and other media that are approved by
law. Such banks are in reality indirect investing institutions for
their depositors.
The first mutual savings bank organized in 1816; two organized
in that year are still operating. The Bowery Savings Bank, which
is the largest in the world, was organized in New York City in
1834.
Although mutual savings banks comprised only 4 per cent of
all banks in the United States at the end of 1950, they held 36
per cent of the nation's savings and time deposits. The following
condensed statement shows the combined assets and liabilities
of all mutual savings banks as of December 31, 1950 (in millions
of dollars).4
Assets
Cash and balances with banks $ 796.9
U. S. Government obligations 10,867.8
Other securities 2,341.6
Real estate and other loans 8,136.8
Other assets 241.8
Total $22,384.9
Liabilities
Demand deposits $ 21.6
Time deposits 20,009.7
Other liabilities 106.4
Surplus and undivided profits 2,247.2
Total $22,384.9
It is interesting to note that the ratio of capital funds to de-
posits was 11.2 per cent; cash and United States Government
obligations covered deposits by 58 per cent.
Character of deposits. Mutual savings banks are organized
without capital stock, and net earnings are distributed to de-
positors as dividends. Surplus earnings over and above dividends
4 Source: Comptroller of the CurreiK-y, Annual Report, 1950, p. 162.
30
are carried to the surplus account, which belongs to the depositors
and serves as a reserve for their protection. Each depositor has an
equitable share in the surplus, irrespective of the period of his
deposit. The mutuals operate under the direction of trustees and
are supervised by state banking authorities.
Savings deposits are time deposits, and the right is reserved
to require notice of intention of withdrawal, varying from 10 days
to 90 days in the various states (60 days in New York State).
This right is rarely exercised. Over their long history, mutual
savings banks have maintained an excellent safety record. And
while only a portion of the mutuals (including those in New York)
have chosen to join the Federal Deposit Insurance Corporation,5
their enviable record, financial strength, insurance of deposits
(in some cases), and strict state regulation provide, for practical
purposes, the same safety and liquidity that can be enjoyed
through commercial bank savings accounts. Similarly, few mu-
tuals have chosen to join the Federal Reserve System. In New
York the banks have, however, subscribed to stock in two central
organizations of their own, both formed in 1933the Savings
Banks Trust Company, designed to advance funds to members on
the security of bond investments, and the Institutional Securities
Corporation, formed to purchase mortgages from member banks.
The amount of deposits that can be accepted from one person
by any one bank is limited to $7,500 (exclusive of accrued in-
terest) in New York and to $5,000 in Massachusetts. This limita-
tion discourages what might be termed "investment" accounts
that might be withdrawn in full on short notice. The rate of in-
terest paid on deposits varies with changes in economic condi-
tions. Competition for funds in 1949 and 1950 caused many banks
to increase their rates to 2 per cent, and a few were paying 2&
and even 3 per cent. The average rate is about 2 per centa rate
that exceeds that paid on commercial bank savings but is lower
than that paid by many savings and loan associations.
5 As of December 31, 1950, 194 mutual banks with $14.3 billions of deposits
were insured by the F.D.I.C, while 335 others, with $5.7 billions of deposits, were
uninsured. Federal Reserve Bulletin.
Balances in mutual savings banks in Massachusetts arc insured by the Mutual
Savings Central Fund and in Connecticut by the Savings Banks Deposit Guarantee
Fund. In all, about 20 per cent of deposits are covered by the state funds in
various states.
SAVINGS BONDS
31
Summary and recent developments. The mutual savings bank
provides a safe place for small savings, legal protection, modest
income, and a convenient means of accumulating a reserve fund.
In view of the splendid record these institutions have achieved,
it is regrettable that their facilities are not available in many more
states than the 17 in which they are located. Although the sav-
ings departments of commercial banks provide substantially the
same service, they produce a lower rate of interest.
An interesting and growing development in the savings bank
field has been the sale of life insurance policies by savings banks
in Massachusetts (since 1907), New York (since 1938), and
Connecticut (since 1941). Such policies have the advantages of
lower premiums (owing to lack of sales commissions and a lower
rate of lapse) and a higher initial cash-surrender value. In 1950
there were in force more than 500,000 policies totaling more than
$525,000,000.6
Non-mutual or stock savings banks, which also confine them-
selves to receiving savings deposits but are owned by stockholders
and operated for their benefit, are no longer important. In New
York and New Jersey only mutual savings banks are now per-
mitted.
4. Accounts in Savings and Loan Associations
General characteristics. Savings and loan associations (also
known as building and loan associations, co-operative banks, and
homestead associations) are institutions that are devoted almost
entirely to the accumulation of funds in savers' accounts and the
investment of these funds in urban mortgage loans. With the ex-
ception of some state-chartered institutions (notably in California
and Ohio), they are mutual and co-operative organizations. There
are approximately 6,025 savings and loan associations with com-
bined assets, at the end of 1950, of nearly $17 billions. They are
the source of about one-third of all the home loans currentlv
obtained by all types of borrowers. The old building and loan
associations, chartered only by states, were organized primarily
for the purpose of co-operative home-financing. Since the early
''Facts You Should Know about Saving Money (Association of Better Business
Bureaus, Inc., 1950), p. 10.
32
1930's, however, the savings-depository function has grown in
importance, and today the savings and loan associations are ac-
tively competing with banks and insurance companies for the
thrift funds of individuals. Their rapid growth is indicated by the
data on savings in the first part of this chapter.
Savings and loan associations operate under both state and
Federal charters. State associations (about 4,500) are chartered
by the states in which they operate and are supervised by state
commissioners. The 1,525 Federal associations, which include
most of the larger organizations, are chartered under legislation
passed in 1932 which set up the Home Loan Bank Board. All
Federal associations are mutual in type, are examined and super-
vised by the Home Loan Bank Board, and must have their ac-
counts insured by the Federal Savings and Loan Insurance Cor-
poration.
Status of the accounts. In the strict sense, savings and loan
associations are not depositories. Savers placing funds in asso-
ciations invest in shares and become owners of the institution,
whereas depositors in banks are legally creditors and have cred-
itors' rights in the event of default.7 Depositors in banks receive
interest; account-holders in savings and loan associations receive
dividends, after operating expenses and reserves have been pro-
vided for. Associations are prohibited by law and custom from
using the terms "deposit" and "interest," although Federal asso-
ciations and some state associations are permitted to use the term
"savings account." The pure mutual association has no capital
stock outstanding.8 It is owned by share-account holders and is
managed by directors elected by them. The directors, in turn,
elect the officers. The term "share account" used by the associa-
tions is derived from the practice of the earlier building and loan
associations whereby borrowers for home-building purposes sub-
scribed for shares, which, when paid up, would be sufficient to
cancel the loan. Share accounts are now opened with borrowers
7 In some states, principally Ohio and California, state-chartered associations are
formed with permanent or "guarantee" capital stock, the owners of which own
and manage the association. The holders of certificates of deposit and savings
accounts are in effect creditors. Federal associations are mutual institutions and
are owned solely by their members or account-holders.
8 See previous footnote.
SAVINGS BONDS
33
from the association and with investors seeking income on then-
savings.
Investment (share) accounts or certificates in units of $100
are sold for full cash payments and receive dividends by check.
Savings (share) accounts permit investment at regular or irregu-
lar intervals and in any amounts; dividends are ordinarily credited
directly to the account, although recent regulations governing
Federal associations give the saver the option of having earnings
paid in cash or credited to his account.9 The regulations govern-
ing Federal associations permit the directors to exempt all ac-
counts of $10 or less from earnings; a number of associations have
not exercised this option.
To stimulate systematic thrift, associations may adopt bonus
plans whereby an additional rate of 1 per cent or less is paid
when an account reaches, say, 200 times an agreed monthly pay-
ment.
The distinction between a bank deposit and an account in a
savings and loan association is indicated by differences in pro-
visions for withdrawal. The savings and loan account is not a
demand account; checks cannot be written against it. From 75 to
85 per cent of the assets of the association consist of mortgage
loans on owner-occupied homes which the borrower pays back in
regular monthly installments. The degree of liquidity provided r-
by a commercial bank is not to be expected under these condi-
tions. Today associations in effect are prepared to meet modest
withdrawals (retirements of shares) on demand; some require
thirty days' notice for withdrawals, except in cases of real emer-
gency. When unable to meet withdrawals, the Federal- and most
state-chartered associations require the holders of share accounts
to file written applications for withdrawal. The institution must
then either pay the amount of withdrawal requested within thirty
days or apply at least one-third and in some states as much as two-
thirds of cash receipts to the holders of accounts in the order of
filing; holders of an account in Federal associations applying for
9 This option applies to "Charter N" associations, which have only the savings
account. "Charter K" associations have both investment accounts and savings
accounts; earnings on investment accounts are paid in cash, while earnings on
savings accounts are credited directly.
34
more than $1,000 receive that amount and their applications are
renumbered and placed at the end of the list. The right is also
given to the board of directors to repurchase not more than $200
of any one account in any month without regard to other pro-
visions.
In recent years almost all associations have been meeting re-
quests for funds in full on demand or on relatively short notice;
such a condition should continue except in periods of severe
economic depression. Cash reserves, availability of rediscount
and borrowing facilities at the Home Loan Banks, and the large
holdings of government securities provide sufficient liquidity for
ordinary purposes. However, the generally less liquid character
of the assets should not be overlooked.
Since September, 1950, the distinction between insured banks
and savings and loan associations with respect to the way in which
insurance features would operate in case of default has been
materially decreased. When an insured commercial or savings
bank is unable to meet the demands of its depositors, the law
provides that the Federal Deposit Insurance Corporation shall
make payment of the insured deposits either (1) by making
available to each depositor a transferred deposit to another in-
sured bank where cash will be available, or (2) in such other
manner as the board of directors of the F. D. I. C. may prescribe.
In practice, where the second alternative has been used, the
F. D. I. C. has made immediate payment in cash. All Federal
savings and loan associations and more than 1,300 state associa-
tions carry and pay for insurance (up to $10,000 per account)
with the Federal Savings and Loan Insurance Corporation, es-
tablished in 1934. Together such associations carry 80 per cent
of the entire savings and loan resources of the country. In the
event of default by any insured institution, the law now provides
that the F. S. L. I. C. shall, when the account is surrendered and
transferred to the Corporation, make available to him as soon as
possible either (1) cash, or (2) a transferred account in a new
insured institution.
At the end of 1950 the F. S. L. I. C. had assets of approximately
$200,000,000, of which 97 per cent consisted of cash and United
States Government obligations. It insured accounts of 2,860 in-
stitutions with combined assets of $13.7 billions. The savings in
SAVINGS BONDS
35
these institutions totalled $11.4 billions, of which 98 per cent,
or $11.2 billions, was fully insured.10
The well-managed savings and loan association provides a
safe place for savings. The major part of its funds are invested in
mortgage loans. The investor cannot expect to receive the higher
returns paid by associations as a result of their earnings on mort-
gages (in comparison with rates paid on bank savings accounts)
and be assured of the same liquidity. In 1950 the rates paid ac-
count-holders in associations ranged from 2 to 4 per cent, with
the bulk of the associations paying 2 and 2% per cent.
Statement of condition. The following combined statement of
condition for all savings and loan associations and co-operative
banks at the end of 1950 is indicative of the character of their
work and the protection afforded account-holders. General and
unallocated reserves were 9 per cent of savings and investment
CONSOLIDATED STATEMENT OF CONDITION
ALL SAVINGS AND LOAN ASSOCIATIONS AND CO-OPERATIVE BANKS,
December 31, 1950
(in millions of dollars)
Assets
Amount
Percentage
of Total
$ 929.6
5.5%
1,505.6
8.9
13,772.1
81.6
62.8
0.4
182.5
1.0
14.8
0.1
417.8
2.5
$16,885.2
100.0%
Percentage
Liabilities and Reserves
Amount
of Total
$14,078.2
83.4%
891.3
5.3
336.0
2.0
All Other Liabilities
294.9
1.7
1,284.8
7.6
$16,885.2
100.0%
Source: Prepared by the United States Savings and Loan League from reports of Home
Loan Bank Board and State supervisory authorities.
10 Housing and Home Finance Agency, Fourth Annual Report, Part 2 (Home
Loan Bank Board), 1951, p. 188.
36
accounts. Cash and government bonds were 17 per cent of ac-
counts. Of course, the showing of individual associations in these
respects would cover a wide range. The investor would do well
to obtain a recent statement of his local association and inquire
carefully into its condition and management. Of special impor-
tance, of course, is the proportion of reserves and undivided
profits to share capital, the liquidity position, and the quality of
the mortgage portfolio.11 Federal associations are required to
credit to reserves at the end of six months at least 5 per cent of
earnings, or the amount required by the insurance regulations
(three-tenths of one per cent of insured accounts), whichever is
greater. The Home Loan Bank Board is authorized to establish
liquidity requirementsbetween 4 and 8 per cent of withdrawable
accountsfor all members of the Home Loan Bank System. The
present requirement is set at 6 per cent. A ratio of 15 per cent
would appear to be a reasonable standard for the larger associa-
tions.
Home Loan Banks. Under the Federal laws dating from 1933,
the Home Loan Bank Board supervises Federal savings and loan
associations, the Federal Savings and Loan Insurance Corpora-
tion, the Home Owners' Loan Corporation (now in liquidation),
and the eleven Federal Home Loan Banks. All Federal associa-
tions are required to hold stock in the Home Loan Banks; other
stockholders consist of state associations electing membership,
and a few savings banks and insurance companies. The original
capital of the Home Loan Banks was provided by the govern-
ment; member institutions subscribed to stock in the amount of
one per cent of outstanding home mortgage loans, purchase con-
tracts, and similar obligations. In 1950 provision was made for
the retirement of the government-owned stock by increasing the
required member institution stockholdings to two per cent of
outstanding home mortgage assets. The chief source of funds of
the Home Loan Banks has been the issuance of consolidated notes
and debentures, of which there were $560,000,000 outstanding at
the end of 1950.
The chief function of the Home Loan Banks is to make loans
to members against home mortgages, government bonds, or stock
11 The investment policy and restrictions on investments of savings and loan
associations are discussed in Chapter 9.
SAVINGS BONDS
37
in the Banks assigned as security. The charter provisions of a
Federal association permit it to borrow up to one-half of its capi-
tal (savings accounts plus earnings credited thereto). The amount
which may be borrowed from sources other than a Federal Home
Loan Bank is limited to one-tenth of such capital. However, with
prior approval of the Home Loan Bank Board, the association
may borrow an unlimited amount from its Home Loan Bank or
from any Federal agency, upon such terms as may be required
by the bank or agency. The use of such borrowing power would
appear to place the account-holders of a savings and loan asso-
ciation at a disadvantage as compared to the savings depositor in
a commercial bank.
CHAPTER 4
SAVINGS INSTITUTIONS AND
SAVINGS BONDS (CONTINUED)
5. United States Savings Bonds
United States Savings Bonds were first issued in 1935 to furnish
a medium of investment for the savings of individuals and to help
meet Federal deficits. During World War II great emphasis was
placed on the accumulation of these bonds, and in the post-War
period several drives have been conducted by the Treasury De-
partment to maintain the interest of investors in these securities.
The growth in importance of this medium of saving is indicated
by the following data showing the amounts outstanding at the
end of selected years (in millions of dollars):
1940 $ 3,195
1945 48,183
1946 49,776
1947 52,053
1948 55,051
1949 56,707
1950 58,019
Following the large issuance during the war, the outstanding
amount of savings bonds, particularly Series E bonds, continued
to increase until 1951, when new sales and the current accrual of
redemption values began to fall behind redemptions.
Series E bonds. Savings bonds are issued in three series: E, F,
and G. Series E bonds can be purchased only by individuals,
while F and G bonds are available to both individuals and in-
stitutions, except commercial banks. The distinctive features of
the Series E bonds are as follows:
(1) These bonds are issued in face-value denominations of
$25, $50, $100, $200, $500, and $1,000. Denominations of $10
are available to members of the armed forces only.
38
SAVINGS BONDS
39
(2) The bonds do not bear any stated rate of interest but are
issued for a term of 10 years and are sold at 75 per cent of face
value. As a consequence, the holder of the bond does not collect
any interest until the bond is redeemed. The 25-per-cent profit
collected when the bond is due represents interest for the period
and is equivalent to an annual rate of 3/3 per cent simple inter-
est and 2.9 per cent compounded semiannually for the period.
UNITED STATES SAVINGS BONDS (SERIES E)
Redemption Values and Income Yields
Redemption
Value
Yield Gained
(If Held)
Yield Lost
(If Redeemed)
Period After Issue
75%
0.00%
2.90%
75K
0.67
3.15
76
0.88
3.26
2 to 2% years
76K
0.99
3.38
77
1.06
3.52
3 to 3)j years
78
1.31
3.58
79
1.49
3.66
80
1.62 .
3.76
81
1.72
3.87
82
1.79
4.01
83
1.85
4.18
84
1.90
4.41
6) 4 to 7 years
86
2.12
4.36
88
2.30
4.31
90
2.45
4.26
8 to 8K years
92
2.57
4.21
40
are redeemed for reinvestment purposes, the rate of yield volun-
tarily surrendered on the unexpired period of the bonds will be
higher than the maturity rate. As shown in the accompanying
table, if a bond is redeemed at the end of five years, the redemp-
tion price of 82 would afford a yield of 1.79 per cent for the five-
year period but would indicate that a yield of 4.01 per cent
would be required from an alternative investment to equal that
which would have been obtainable through holding the savings
bond to the maturity date.
(4) Starting in March, 1951, the owner of a matured Series E
bond was given three options: (1) to redeem the bond; (2) to
retain the bond for a period not to exceed 10 years, during which
time interest accrues at a rate of 2)s per cent simple interest for
the first seven and one-half years and thereafter at a higher rate
sufficient to provide an aggregate return for the 10-year extension
period of 2.9 per cent compounded;1 (3) to exchange the E bond
for a Series G bond. The same options were to apply to all out-
standing E bonds at their maturity, and to all new Series E bonds
issued in the future.
(5) The bonds are nonnegotiable securities and are redeem-
able only by the registered owners, thus protecting the holders
against loss arising from theft, forgery, fire, and similar causes.
(6) The bonds may be purchased only by individual persons
and will not be issued in the names of corporations, banks, trus-
tees, or guardians. The bonds may be registered in the name of
one individual or of two individuals as co-owners (either of whom
may redeem the bond) or as owner and beneficiary.
(7) The maximum purchase of these bonds permitted to any
person is $10,000 in maturity value ($7,500 cost price) for each
calendar year of issue, or $20,000 if co-ownership registration is
used. These limits should take care of the vast majority of in-
vestors. And, of course, several times the limit could be bought
in the same family.
(8) The bonds may be purchased at banks, at post offices, or
directly through the Treasury Department at Washington.
Series F and G bonds. Series F bonds are similar to Series E
bonds in that they are of the appreciation type, but they mature
1 This would bring the redemption value of extended Series E bonds to $117..50
at the end of 7'A years and $13-3.33 at the end of 10 years.
SAVINGS BONDS
41
12 years from the date of issue and cost $74.00 per $100 of ma-
turity value. The longer maturity results in a yield, if held for
the 12 years, of 2.53 per cent compounded semiannually. They
are, however, redeemable at the option of the holder only after
six months from the date of issue, on one month's written notice.
The redemption prices gradually increase to maturity, and, like
the Series E bonds, if these bonds are redeemed before maturity,
the yield lost on redemption value to maturity is higher than the
maturity rate, although lower throughout the whole period than
on the Series E's. Denominations of Series F bonds run as high
as $10,000, and they may be registered in the name of associa-
tions, partnerships, trustees, and corporations, as well as in the
names of individuals, except commercial banks accepting demand
deposits. The limit on annual purchase is $100,000 issue price
(Series F and G combined). Series F bonds are available at the
Federal Reserve Banks and from the Treasurer of the United
States.
Series G bonds also mature 12 years from date of issue, but,
unlike the two other series, these bonds are not sold at a discount
but pay interest by check to the registered owner at the rate of
2.5 per cent. They are available in denominations of from $100
to $10,000 and are bought and redeemed at face value. Their
registration, redemption, and purchase features are the same as
those for the Series F bonds, except that the redemption value
declines from $98.80 per $100 at the end of the first six months
to $94.70 at the end of five years. Thereafter the value rises to
face value at maturity. They are the only one of the three series
that does not provide at least the original purchase price upon
redemption.
Investment characteristics. In some respects savings bonds,
especially the Series E bonds, are outstanding investment bar-
gains. They are as safe as any investment can be. They do not
suffer from market-price fluctuations. They are completely liquid
and their exact redemption value is known at all times. If held
to maturity, their yield is attractive in relation to corporate bonds,
whose higher yields do not compensate for the additional risk
assumed. Their ease of purchase, ease of registration and replace-
ment, and co-owner and beneficiary provisions are most attrac-
tive features.
42
The objection that the Series E and F bonds do not provide
current income is probably not serious in most cases, as the sav-
ings placed in these bonds are usually not expected to produce
such income. And if some income is desired after a few years, a
modest portion of the bonds can be cashed without disturbing
the original principal.
Savings bonds have two specific disadvantages: (1) they are
not transferable and so may not be used as collateral; (2) if re-
deemed during the early years, their yield is lower than that
available from savings deposits although higher than the yield
on marketable short-term Treasury securities, and the yield to
maturity is lower than that paid by some savings and loan asso-
ciations. And these bonds have, of course, the same disadvantage
that adheres to all fixed-principal and fixed-income investments
in inflationary times, namely, that their real value declines with
the rise in the price level. The awareness of this factor, together
with the availability of increased rates elsewhere, has lessened
their appeal considerably since the outbreak of the Korean crisis.
Savings bonds do not enjoy any income tax preference. How-
ever, the interest on Series E and F bonds may be reported for
tax purposes in either of two wayseach year as it accrues, or at
maturity when the total interest is received. The latter method is
more convenient, but in using it the investor may find that the
rate at which his income is taxed has increased during the life of
the bond, and he will pay taxes on the entire interest at this
higher rate.
6. Life Insurance and Annuities as Investments
The life insurance companies have long provided the most
important form of savings in the country. Their assets are in ex-
cess of $63 billions, their policy reserves approximate $55 billions,
and their annual income exceeds $11 billions, of which three-
fourths is derived from premium payments of policyholders.
(Additional data on the industry are given in Chapter 10.)
The investment aspects of life insurance. Life insurance enters
into investment planning in at least three major respects: (1) in-
surance provides the only feasible method by which most in-
vestors can provide an adequate estate for dependents; (2) in
SAVINGS BONDS 43
most insurance contracts there is a substantial investment element
in the form of a policy reserve that represents savings and that is
available in the form of cash values or policy loans in case of
emergency; (3) the insured may create an estate for himself after
the need of protection for dependents has declined or disap-
peared. An extensive discussion of the principles of insurance and
of the various types of policies would be out of place in this vol-
ume, but the following summary may prove useful. Discussion of
government, group, and industrial insurance and many special
combination-type policies is omitted.
The premium paid for insurance is usually a level premium,
that is, it is the same each year even though the risk of death
increases with age. It is fixed at the time the policy is issued and
is based on the age of the insured. It consists of three elements:
(1) a sum contributed toward the company's operating expenses
this is the Office premium" or "load"; (2) an amount necessary
to reimburse the insurance company for carrying the risk of pre-
mature death of the insured; (3) an amount set aside as a reserve
and invested at a "guaranteed" rate so as to cover future death
loss at the more advanced age. Disregarding the first item, it is
seen that part of the premium goes for current protection and
part into the policy reserve or investment element. It is the re-
serve or investment element that constitutes the cash value that
is available in cash (after a stated period, possibly the first two or
three years), through cancellation of the contract or in the form
of a policy loan. The reserve may also be used to extend the term
of the insurance or to purchase a paid-up policy for a reduced
amount of insurance if the insured wishes to stop paying premiums
on the original policy.
The premium is calculated on the basis of: (1) the probability
of death age by age as indicated by a mortality table; (2) an
assumed rate of earnings on invested reserves (now as low as 2
or 2/2 per cent in new policies); (3) expected selling expense,
office expenses, and taxes of the company; and (4) the type of
policy issued. Savings on the first three of these, the cost elements,
may be substantial, and in the case of mutual companies (and
participating policies of stock companies) such savings may be
returned to the policyholder in the form of "dividends." Or the
dividends may be left with the company at interest, be used to
44
reduce the annual premium, or be used to purchase additional
paid-up insurance. The dividend is, of course, not a true profit but
simply a rebate of excess premium paid.
Mortality rates have been going down for many years in this
country. But interest rates have been declining and company
expenses increasing sufficiently to more than offset the mortality
rate decline and thus to increase insurance premiums.
Types of policies from the investor's point of view. In com-
paring the cost of similar policies issued by different companies,
it is important to make sure that their provisions and benefits are
identical and to take into consideration the net cost over a period
of years, that is, premiums less any dividends. Another and per-
haps preferable method of determining the comparative net cost
is to compare the total premiums paid in, less dividends, less
the cash-surrender value, at the end of a given period. This cost
may be zero, or even a negative amount. It is important to remem-
ber that dividends are not paid in regular amounts and are not
assured, but depend on the company's experience.
The following annual premiums at age 35 for various types of
policies and the cash-surrender values at the end of 20 years were
quoted by a stock insurance company in 1949:
Premium
per Thousand Cash Value, 20 Years
20-Year Term $12.34 $ 0
Ordinary Life 23.33 517
20-Payment Life 35.01 840
20-Year Endowment 47.62 1,000
Since the year-to-year cost of protection for each $1,000 of
insurance at risk is the same for each age of issue, the difference
in gross premiums on various policies (at the same age) depends
on the investment element in the policy. This investment element
varies considerably according to the type of policy purchased.
The term policy provides for the payment of face value only if
death occurs within the stipulated period in very much the same
way as a fire insurance policy protects property for a certain
period. It has no recovery value at the end of the term. Since
nothing is paid for survival, it is not necessary for the insurance
company to accumulate a fund for that purpose. Longer-term
contracts, say, for 15 to 20 years, have a slight cash value, but
this element is negligible and declines to zero at the expiration
SAVINGS BONDS
45
of the period. To the investor desiring the greatest temporary
protection at the least outlay, the term policy is the best choice.
As shown by the above schedule of rates, an annual premium of
$100 would buy about $8,100 of protection for 20 years through a
20-year term policy, $4,300 in ordinary life protection, $2,860 in
20-year paid-up life insurance, and only $2,100 in 20-year endow-
ment insurance.
Arguments for the use of term insurance include: (1) the ele-
ment of maximum protection per dollar of premium outlay that
has just been cited; (2) the possibility of investing the difference
between the premium on term insurance and a higher-premium
form at a higher rate than would be earned by the insurance
company; (3) the possibility of converting into a permanent form
of insurance without medical examination within a certain period
of time before the expiration of the term policy if permanent pro-
tection is needed; (4) the use of the term policy to insure the
payment of debt in case the borrower dies before the debt ma-
tures.
Arguments against term insurance are: (1) the inability of
many people to save systematically unless compelled to save in
order to keep insurance in force; (2) the lack of a reserve that
would be available in cash in emergencies and that would keep
the policy in force if the insured were unable to meet his pre-
miums because of financial difficulties; (3) the high cost or even
impossibility of renewal at the expiration of the period; (4) the
natural lethargy that leads to failure to convert and hence to ex-
piration of the protection. Perhaps the best plan for the young
man is to take out convertible term insurance to the full amount
of his protection need and change to permanent insurance as soon
as he can afford to do so. To offset the practical difficulties that
this plan involves, the Family Income policy is recommended.
This policy combines ordinary life with decreasing term insurance
and pays a monthly income upon the premature death of the in-
sured until the expiration of a specified date (say, 10 or 20 years
from date of issuance) and the face of the policy on that date. The
annual premium is somewhat greater than that for term insurance
and less than that for whole life insurance.
Ordinary whole life policies (often called straight life policies)
provide protection and require premiums until the insured dies.
46
(The policyholder is officially dead at age 96 or 100depending
on the mortality table usedand his policy matures and is paid
at that age.) Advantages of this form are: (1) the insured is never
without protection; (2) the savings or investment element is sub-
stantial; (3) at retirement or when the insured no longer has
dependents the cash value may be taken in cash or may be used
for an annuity; (4) if at a later age it becomes difficult to continue
the premiums, the paid-up values may be used to extend the in-
surance for a term or to buy a reduced amount of protection. The
chief disadvantage is that the maximum amount of temporary
protection, say, during the establishment of a family by a younger
man, is not obtained.
In limited-payment life policies, premiums are paid at a higher
rate for a period (say, for 20 or 30 years), after which the policy
continues in force for life without further payments. The policy
has not matured at the end of the 20 or 30 years, but the insurance
remains in force. Advantages of this form are: (1) premium pay-
ments are made during the period when the policyholder is most
capable of earning and do not become a burden on retirement in-
come; (2) there is a more substantial investment element in the
form of cash value owing to the rlecessity of accumulating re-
serves in the 20 or 30 years that will protect against death loss
after the premium payments are no longer required. The major
disadvantage is that the insured has substantially less protection
per dollar of premium than is afforded by term or whole-life in-
surance during the period when the protection may be most
needed (in other words, the possible overemphasis on savings
and underemphasis on protection).
Endowment policies offer protection for a specified period of
time, say, 20 or 30 years, at the end of which the policy matures
and the amount of the policy is paid to the insured himself. Such
policies combine relatively small protection with a relatively
large investment element. In a non-technical sense, the endow-
ment policy combines an increasing savings fund protected by
decreasing term insurance. If the insured dies during the period,
the beneficiaries of the insured are paid the face amount; if he
lives, he collects it himself. Advantages of endowment insurance
are: (1) where the need for protection is small and where the
need for savings is predominant, the insured is forced to save in
SAVINGS BONDS
47
order to keep his policy in force; (2) the goals whose fulfillment
is planned through insurance may be met whether the insured
lives or dies; (3) the very substantial cash value provides a cash
fund or fund for conversion into retirement protection. The main
limitations or disadvantages are: (1) protection expires when the
policy matures; (2) low protection is afforded per dollar of pre-
mium.
Investment merits. Life insurance policies offer, in various de-
grees, an interesting combination of protection and investment.
However, many people feel that the two should not be combined
in one contract. The rate of return on that part of the premium
which represents an investment commitment is below that which
an individual might procure from the direct purchase of sound
securities but is higher than bank interest. However, the lower
rate of return obtained by the insurance company is compounded
something the individual investor rarely manages to accomplish.
In addition, the interest compounded is tax-free. The compulsory
savings requirement, the encouragement to systematic thrift, the
safety of the funds derived from the caution and skill and degree
of diversification with which the large insurance companies make
their investments, and the liquidity, convenience, and freedom
from managerial care on the part of the insured are strong argu-
ments for substantial investment values in life insurance contracts,
at least for the majority of investors.
Annuities as investments. The annuity is a form of investment
designed to produce a maximum return with safety at or prior
to retirement age. The contract provides for the receipt of a
series of equal annual installments immediately or after an agreed
age, usually so long as the annuitant lives, in return for a lump-
sum payment or regular annual payments before retirement on
the part of the policyholder. The basis of calculation is the age
of the annuitant. The longer the annuitant lives in comparison
with the average, the more he receives in excess of what he has
paid for his policy. If he is short-lived, he receives back much less
than he has invested. The life annuity is simply a means of making
sure that a given sum of capital will provide a specified income
which cannot be outlived. Since a part of the principal, in addi-
tion to the interest earned, is returned each year, the return to
the annuitant is larger than that which would be produced by
48
interest income from the fund alone. The cost of this higher in-
come is the complete liquidation of principal at the death of the
annuitant, at least in the straight life annuity described below.
The more important types of annuities can be described very
briefly. A single-premium annuity is purchased by the payment
of one lump sum, the payments to begin at once for the life of the
annuitant. Installment-payment annuities call for premiums peri-
odically over a period of years to the date of retirement, after
which the annuitant receives an income for life. A life insurance
annuity is purchased by the proceeds of a life insurance policy
which are distributed as an annuity in lieu of a lump sum. Most
life insurance policies provide for this type of settlement option.
From the standpoint of the time of receipt of benefits, annuities
can be classified as immediate, which pay a given sum periodically
for life following purchase, or deferred, in which income does not
begin until some time in the future, usually at the estimated end
of the annuitant's income-producing period. Possibly the most
common type of annuity is the installment-payment type whose
income will be deferred until the retirement age of the policy-
holder. Joint and last-survivorship annuities pay an income to
two or more persons, such as husband or wife, as long as either
survives.
A straight life annuity provides income to the annuitant for his
lifetime, regardless of how long that may be. When death occurs,
the income ceases. The disadvantage of such an arrangement is
that, in case of early death, the annuitant may have received only
a fraction of what has been paid in to the company. The annui-
tant, and more especially his heirs, may fail to appreciate that
this is the price paid for the income that would have been re-
ceived if he had lived longer than the average. Consequently,
such straight life annuities are not so common today as annuities
with special features attached, such as the life annuity certain,
which pays an income for life but guarantees to make a minimum
number of payments, such as for 10 or 20 years, irrespective of
the time of death of the annuitant. An installment refund life
annuity pavs an income for life but provides for a continuation
of installments to beneficiaries until the payments total the origi-
nal principal, should the annuitant die before that time. A cash
refund life annuity is similar but provides for the payment in cash
SAVINGS BONDS
49
of the balance of the original principal. Such annuities often con-
tain substantial cash values. The advantage of the refund type is
that income or principal is available to take care of dependents
in the event that the annuitant should die before the dependents
have economic independence.
The cost of annuities and the income received from them, of
course, depend on the age and life expectancy of the annuitant,
the rate earned by the insurance company, and the form of the
policy. The following rates show the amount of a monthly straight
life annuity that can be purchased with an immediate lump-sum
payment of $1,000, based on rates quoted in 1949, assuming an
interest rate of 2% per cent.
Age
at Purchase
Annuity per Month
Male
Female
50
$4.61
$4.15
55
5.20
4.61
60
5.97
5.20
65
6.97
5.97
70
8,32
6.97
It will be noted that the annuity increases with the age at the
time of purchase and that the return is much higher (2 times at
age 60 for a man and age 65 for a woman) than could be obtained
by investing the $1,000 at 3 per cent. This is because the return
consists of both principal and interest.
Annuities have the advantage of safety, convenience, freedom
from care, and compulsion to save. And most important of all,
they offer the assurance that the annuitant will not outlive his
income. For the investor of limited means, a definite income for
retirement is assured. For the man of wealth, the purchase of
annuities will provide a fixed income (using part of capital) and
leave a larger portion of the total fund free for investment in
stocks or other investments. Annuities suffer, as do all fixed-income
investments, from the risk of reduced purchasing power in the
event of price inflation. And premium rates have been increasing
in recent years. But the widespread recognition of their advan-
tages is indicated by the fact that at the beginning of 1951, 3,650,-
000 annuities (group, individual, and contracts supplementary
50 SAVINGS INSTITUTIONS
to life insurance policies) were in force with legal reserve com-
panies providing $1,280,000,000 immediate and deferred income.2
Federal Social Security benefits and the growing number of pen-
sion plans also attest to the desire for the financial security pro-
vided by the annuity type of arrangement.
2 Institute of Life Insurance, Life Insurance Fact Book, 1951, p. 29.
CHAPTER 5
CHARACTERISTICS OF CORPORATE
BONDS
Scope. The purpose of this chapter is to discuss the character-
istics of corporate bonds from the viewpoint of the investor.
Bonds of governments and other issuers are described in later
chapters. The order of discussion is: (1) general characteristics,
(2) reasons for use, (3) importance of bond financing, (4) bond
indentures, (5) the bond instrument, (6) classification of bonds
according to security, (7) classification as to purpose, (8) classi-
fication by form of issue, (9) classification by redemption and
maturity features, (10) classification by manner of participation
in income, (11) investment position of bonds. The classifications
referred to are not mutually exclusive, and a single bond issue
might fall under three or four groupings.
General characteristics. Bonds represent long-term corporate
debt, as contrasted with stocks, which represent ownership. Bond-
holders are therefore creditors of the issuing corporation. Claims
of all bondholders have priority over the stockholders' interests,
and particular bond issues may enjoy preferred claims, but only
when the nature of the preference is definitely stated in the in-
strument, as in the case of a first mortgage issue. Bonds usually
contain a promise to pay a fixed rate of interest, and their principal
is due and payable on a definite date. The bondholder is entitled
to the fixed income and principal but to no more.
Bonds normally give the holder no voice in management, ex-
cept in case of default. Failure on the part of the debtor to meet
the promises made in the bond indenture gives the bondholder,
through the trustee named in the indenture, the right to take legal
actioneither to foreclose on any pledged property or to sue for
breach of contract.
The position of the bondholder is therefore in sharp contrast
51
52
CHARACTERISTICS OF CORPORATE BONDS
with that of the stockholder or owner. The bondholder takes
riskbut relatively less risk than the stockholder, in the same
corporation. He has made a loan, he expects a fixed rate of income,
and he anticipates a full return of his capital at a definite future
date. The investment quality of his bond depends on the degree
to which the debtor can be expected to fulfil these promises.
Reasons for issuing bonds. When governments are unable to
meet their expenses from current tax income, they have no choice
but to borrow, through the issuance of bonds or other debt in-
struments. Corporations, on the other hand, have a wider choice
of methods with which to finance their operations. Among other
ways, they may issue equity-type securities (within the limits
set by their credit and by market conditions). Why do they incur
the risk of borrowing? Five main reasons explain the use of bonds:
1. To lower the cost of funds. Investors are usually satisfied
with a lower return from bonds than from preferred or common
stock. The advantage of cheaper financing is, however, accom-
panied by greater risk on the part of the corporation.
2. To trade on the equity. Using borrowed funds at a cost lower
than the rate the company expects to earn on their use increases
the potential returns on the equity or owners' investment. Un-
fortunately, because the rate on bonds is a fixed charge, trading
on the equity may also lead to deficits when earnings decline.
3. To widen the source of funds. Funds can be attracted from
many investors and from investing institutions that are unwilling
or unable to purchase stock.
4. To preserve control. Since bonds ordinarily carry no voting
rights, an increase in debt does not disturb the voting power of
present owners, at least as long as the bonds are not in default.
5. To effect tax savings. The interest on bonds is deductible in
figuring corporate income for tax purposes, whereas dividends
on stock are not.
Notwithstanding the above advantages, there are definite limi-
tations on borrowing that the wise corporate management feels
obliged to follow. When these limitations are disregarded, the
investment position of the bonds suffers, and the corporation may
find itself in grave difficulties. In the later sections of this book
much attention will be given to the tests of sound financial policy.
CHARACTERISTICS OF CORPORATE BONDS 53
Importance of bond financing. The accompanying table shows
the degree to which corporations have relied on bonds during
the period 1941-1950. It is interesting to note that bonds com-
prised nearly 80 per cent of the total corporation securities issued
during the period. It should be noted, however, that equity capi-
tal, as contrasted with borrowed capital, also includes reinvested
earnings, so that the figures do not reveal the whole picture of
the extent to which corporations have relied on debt as against
ownership for new financing.
NEW CORPORATE SECURITY ISSUES IN THE UNITED STATES
Bonds and
Corporate
Notes
Year
Preferred
Stock
Common
Stock
Total
1941
$2,320
$ 219
$ 80
$2,619
1942
913
110
19
1,042
1943
907
131
43
1,081
1944
2,669
411
101
3,181
1945
4,938
1,036
284
6,258
1946
4,570
1,269
813
6,652
1947
4,802
846
670
6,318
1948
5,608
443
497
6,548
1949
4,576
398
627
5,601
1950
4,633
616
674
54 CHARACTERISTICS OF CORPORATE RONDS
in the case of debt securities registered under the Securities Act
of 1933. It sets forth the qualifications of the trustee and outlines
the material concerning the trustee's actions that must be included
in the indenture.
The bond instrument. The bond certificate itself contains only
a summary of the main provisions of the borrowing. It is in effect
a long-term promissory note. Its title usually indicates the name
of the issuer, the rate of interest, the date of maturity, and some
suggestion of the nature of the security, if any. The face amount
of each bond is customarily $1,000 and represents part of a large
issue that has been divided into small units for convenience in
distribution. A fixed annual interest rate is stated on each bond,
interest payments usually being made semiannually. Interest is
collected by the owner through the deposit of coupons detached
from the bond or of a check from the issuer. Practically all bonds
bear definite maturity dates; a small group, however, are perma-
nent loans. Usually, bonds are secured obligations, but many
important issues are not. Peculiarly enough, some of the highest-
grade issues are, technically speaking, unsecured bonds.
Although all bonds are essentially similar as representations
of indebtedness, many variations are found in practice. The chief
difference between bonds is in the nature of the claim that the
bondholder has against the issuer. That bond which has a prior
claim naturally represents the safer security, taking precedence
over any other bonds issued by the same debtor. The title of the
bond, which seldom indicates the degree of priority, is usually
taken from the nature of the instrument, such as first mortgage,
collateral, or debenture; or from the purpose of issue, such as
adjustment, refunding, or consolidated; or from some special
feature, such as sinking fund, convertible, or external. In nu-
merous cases, a combination title is used, such as first consoli-
dated, adjustment income, or first and refunding. The title,
however, serves to distinguish the issue more than to reflect the
investment position. Not all first mortgages are so in fact, and,
even when correctly named, first-mortgage bonds may prove in-
ferior to many "unsecured issues.
Further to confuse the investor, one company, especially if
it is a railroad, may have several issues outstanding, with the
question of priority of claim most complicated. Moreover, one
company with numerous bonds of its own may be directly or
indirectly responsible for the payment of bonds issued by affiliated
companies. The Illinois Central Railroad had outstanding in 1950
27 bond issues or series, in addition to its equipment obligations.
Each one of these bonds fits into a definite sequence of claim
upon earnings. Industrial companies usually have relatively few
issues, and these are of a correspondingly simpler nature
Titles based upon security. The most popular designation of
a bond title is that which is based upon the nature of the security
behind the obligation. The inference is plausible that, in many
cases in which the title is based upon another consideration, the
cogent reason is to avoid a term that would indicate a weak under-
lying situation. Numerous issues that represent little better than
unsecured claims adopt harmless titles such as gold 5's or sinking
fund 4's. The Plain Bonds of the Boston and Maine Railroad con-
stituted a rare example of corporate frankness in this interesting
matter of terminology. Under ordinary conditions where definite
security is available, a title is selected that patently carries this
assurance to the investor, such as first mortgage 3s, refunding
mortgage 4s, or prior lien 3%'s.
Mortgage bonds are the most common form of secured issues.
A mortgage bond is secured by a lien on specific property de-
scribed in the indenture, and the protection afforded by the mort-
gage depends on the priority of the lien and the value of the
property pledged. This may be the entire fixed property or only
a certain section of it, as in the case of railroad divisional bonds.
The investor should be acquainted with certain features in the
mortgage that may help or hinder his interests. If the mortgage
is closed, no more bonds may be secured by the same lien. How-
ever, corporations have found that such issues make future financ-
ing difficult. The open-end mortgage is designed to meet this
situation. Under an open mortgage, more bonds secured by the
same lien may be issued, but certain protective provisions are
required to prevent the dilution of the original security: (1) that
additional bonds be issued in proportion (often 75 per cent) to
new property added, and (2) that additional bonds be issued
only when aggregate interest charges on new and old are ade-
quately earned (say, twice). The effects of expansion of debt
(usually in successive series) are also limited if the open-end
56 CHARACTERISTICS OF CORPORATE BONDS
mortgage contains an after-acquired-property clause which pro-
vides that all property "hereinafter acquired" is included in the
property pledged.
A further covenant that all investors should seek is the penalty
clause for failure to meet the various covenants in the indenture,
under the terms of which default in any specified promise renders
the entire principal immediately due and payable.
Mortgage bonds may be divided into senior and junior liens,
the adjectives referring to priority of claim rather than to date of
issue. The senior liens, which hold the first claim upon both earn-
ings and assets, comprise first mortgages and prior liens. As the
title indicates, first mortgage bonds have precedence of claim
upon earnings and properties. The Duquesne Light (Pittsburgh)
First Mortgage bonds illustrate such an issue. At times the senior
issues are called prior liens, illustrated in the Missouri-Kansas-
Texas Prior Lien bonds which are senior issues of the company
with respect to part of its property but which constitute a second
lien on the main line of the system. Mortgages given in payment
for property purchased are styled purchase money mortgages
(such as the Reading Co. Purchase Money 4's of 1952) and take
precedence over claims against the property acquired, despite
after-acquired clauses in mortgages previously issued by the
purchasing company. The senior group also includes a good num-
ber of apparently junior issues, which are, in many cases, a com-
bination of a large senior claim and a small junior position, or
which have a small amount of prior bonds, or which have gradu-
ally advanced in rank with the retirement of earlier claims. The
Pennsylvania Railroad Consolidated Mortgage bonds are junior
to only $1,800,000 in prior Hens.
The junior bonds are those that have a secondary claim upon
the corporate property. From the viewpoint of the investor, it
would be most helpful if every bond bore a numerical adjective
indicating the position of the security, as shown in the case of the
Louisville & Nashville Southeast & St. Louis Division Second
(now First) 3's of 1980. Corporations, however, are reluctant to
disclose thus openly the position of junior issues; they prefer less
significant and, in some cases, misleading titles, such as general,
or unified, or consolidated, or first refunding. All refunding mort-
gages, as the title indicates, are originally, at least, junior claims,
even when a definite part is reserved to retire the existing first
mortgage. Eventually, as before stated, the refunding mortgage
may become a first claim, but, practically speaking, few such in-
stances are to be found outside of the public utility field. The
Missouri Pacific First and Refunding 5's of which over $224,000,-
000 were outstanding in 1950, were subordinate in claim to only
$1,140,000 in the prior liens that then remained unpaid.
Bonds which are secured by the deposit of other bonds and
stocks are generally termed collateral trust bonds. Just as in the
case of mortgage bonds, in the event of default the collateral can
be seized and sold. The most frequent users of this type of bond
are holding or parent companies which have as their main assets
securities of other companies. Industrial and public service com-
panies sometimes issue collateral bonds when all of their fixed
property is pledged, or they may issue bonds secured by both
mortgage and the deposit of securities.
Investors should study thoroughly the three factors that de-
termine the investment standing of collateral trust bonds: (1) the
nature and value of the securities pledged; (2) the general credit
of the issuer; and (3) the specific protective provisions of the
indenture. There should be an ample spread between the value of
the collateral and the amount of the debt, and the issuer should
be required to maintain this differential. Especially if the value
of the collateral is doubtful, the investor may have to rely chiefly
on the general earning power of the company, for, like mortgage
bonds, if the specific security is worthless, the bonds become in
effect a general claim along with unsecured debt. Any clause in
the indenture that permits substitution of collateral should be
given special scrutiny. The investor should be particularly wary
of collateral trust bonds that are secured by common stocks of
companies that themselves have bonds and preferred stock out-
standing. Under these conditions the collateral trust bonds are in
reality junior securities.
A third group of bonds consists of those secured by the promise
to pay of a company other than the issuer, and includes guaran-
teed, assumed, and joint bonds. The guarantee may be direct,
covering interest, or interest and principal, or it may arise through
a lease contract whereby the lessee agrees to pay to the lessor
a sum sufficient to cover the interest on the bonds. Assumed bonds
58 CHARACTERISTICS OF CORPORATE RONDS
are issues of a company that has been acquired by another by
merger or consolidation or as a result of the reorganization of the
original issuer. In taking over the property of the original issuer,
the debt of the issuer has been assumed by the successor com-
pany. Joint bonds are the direct joint obligation of two or more
concerns or, more likely, obligations of a company that operates
property used by both, such as a terminal, and whose bonds are
jointly guaranteed by the users.
Assumed, guaranteed, and joint bonds depend for their invest-
ment quality on: (1) the property and earnings of the original
issuer, and (2) the value of the additional promise to pay of the
guaranteeing or successor concern. If both of these two elements
are very strong, the issue will command high investment respect.
The best examples are found in the railway field, where the issues
of small corporations that have long since ceased to operate their
own properties have been guaranteed or assumed by a large
company. If the property is important to the system, such issues
rank with the senior issues of the system.
Although these types of bonds have been discussed under the
heading of secured issues, it is important to note that they may
be either mortgage bonds or unsecured bonds. The factor that
gives them special interest is the addition of the credit of a second
corporation, or possibly of several other corporations, as in the
case of Cincinnati Union Terminal Company First Mortgage
bonds, which have a first lien on the terminal property and in
addition are jointly and severally guaranteed by seven railroad
companies.
A fourth group of bonds comprises the debenture issues, which
are not secured by a lien or any specific assets but rank with the
general debt of the issuer. All obligations of the United States
Government, all bonds of states, and most municipal bonds be-
long in this category, although the term debenture is reserved
for unsecured corporate issues. A common provision in the in-
dentures of modern debenture bonds provides that, if the com-
pany should issue any mortgage debt, the debentures will be
similarly secured. Thus, a debenture issue may move up into the
secured category and still be designated by the original title.
^ Debentures are issued by companies with credit standing rang-
ing from very strong to weak. The debenture issues of the Ameri-
can Telephone and Telegraph Company carry an Aa rating. The
strongest industrial corporation bonds are debentures. The fact
that bonds are unsecured does not weaken their investment status
if they are the only long-term debt of the issuer and if the general
assets and earning power of the issuer provide ample protection.
This suggests that the main strength of any bond issue, secured
or unsecured, lies in the earning power of the borrower. But be-
cause debentures lack a specific lien on assets, their position may
deteriorate if excessive equal or prior debt is issued, or if their
backing by general assets, and working capital in particular, is
weakened by subsequent developments. It is important that the
investor check carefully the protective provisions in the deben-
tures that are designed to protect their status. Common provisions
include: (1) the equal-coverage clause mentioned above, pro-
viding for securing the debentures equally with any new mortgage
debt, (2) provision against the payment of dividends that would
reduce net assets below a certain figure, (3) requirement of the
issuer to maintain a certain ratio of current assets to current lia-
bilities before dividends may be paid, (4) limitation of the total
funded debt, including the debentures, to a certain proportion of
the total assets or of the capital stock, or, more frequently, to an
amount on which the interest is earned a certain number of times.
Debentures frequently include a sinking fund to provide for
regular reduction in the amount outstanding and, to give them
a speculative touch, are often made convertible into common
stock.
Debentures are used most frequently by industrial corporations
and much less frequently by railroads and public utilities, which
customarily issue mortgage bonds. Except in unusual cases, the
debenture bond of a railroad is preceded by layers of secured
debt and is therefore a junior security of secondary quality.
In passing, mention should be made of a rare (in American
finance) type of security called debenture stock. Only inspection
of the terms of the issue will reveal whether this hybrid-named
investment is a debenture bond or a preferred stock.
Titles based upon purpose of issue. The purpose for which the
bonds have been issued forms a second basis for the selection of
a title. The underlving reason may be to take advantage of a
favorable investment attitude toward certain classes of securities,
as illustrated in the case of equipment trust notes; or to avoid
the admission of a junior lien through the use of a title such as
adjustment mortgage. This method of styling bonds is, however,
not without advantages, irrespective of the motive. Investors
should be very much interested in the use to which their funds
are put, since that alone is an important test of safety.
Adjustment bonds are issued in the reorganization of companies
in financial difficulties. In practically all cases, they are received
by investors in exchange for old securities retired in the new plan,
under conditions whereby interest is payable only if earnings
permit. They are a leading type of income bond (see below).
Although these bonds are usually issued under clouded conditions,
the eventual success of the company, as shown in the case of the
Atchison, Topeka, & Santa Fe Railway Adjustment Mortgage 4's
of 1995 (issued in 1895) may place the bonds in the investment
category. The Adjustment Income 5's of the Hudson and Man-
hattan (issued in 1913) have fared less auspiciously. Adjustment
bonds are usually protected by a junior mortgage. Foreclosure is
ordinarily permitted for default in the payment of principal and
in the payment of interest if it has been earned.
Bridge bonds are issued to finance the construction of bridges.
Bonds issued by public authorities for the construction of bridges
(such as the George Washington Memorial Bridge between New
York and New Jersey, which cost more than $50,000,000) are
secured primarily by the revenues of the bridge and, in rare in-
stances, by the taxation power of the public authorities. Bonds
issued to finance the construction of railroad bridges (such as the
Hell Gate Bridge in New York) are chiefly the mortgage obliga-
tions of a subsidiary operating company (the New York Connect-
ing Railroad Company) guaranteed by the roads using the bridge
(the Pennsylvania and the New Haven). Such bonds are likewise
highly regarded. Bonds issued by private corporations for the
construction of automobile toll bridges, however, are generally
regarded as speculative, largely because of their poor record over
recent years. Noteworthy examples of unfavorable experience
with bridge bonds of private companies are afforded in the cases
of the International Bridge (Detroit-Windsor) and the San
Mateo-Hayward Bridge across San Francisco Bay.
Consolidated mortgage bonds are those issued for the purpose
of consolidating into one issue several separate bond issues. They
are ordinarily the result of refunding operations and often involve
a first mortgage on one part and second or other mortgages upon
other parts of the company's property.
Divisional bonds are railway mortgage bonds secured by a first
lien on a division or section of the system. Since they precede
other junior mortgage issues with respect to a claim on a certain
division, they are also classified as underlying bonds.
Equipment trust obligations in the form of certificates are
issued to finance the purchase of equipmentnotably railway
rolling stock on the partial-payment plan. Funds for the payment
of such purchases are obtained by paying an advance rental or
down payment of from 20 to 25 per cent and securing the balance
through the sale of serial obligations payable over a period of
from 10 to 15 years. In 1948, the Wheeling and Lake Erie Railway
purchased equipment with a value of $2,000,000. The purchase
was financed through a cash payment of $400,000 (20%) and
the sale of $1,600,000 in 2%% equipment trust certificates matur-
ing at the rate of $80,000 semiannually for 10 years. In 1950
the Southern Pacific Company purchased 19 Diesel-electric freight
and switching locomotives, 598 steel flat cars, 31 sleeping cars,
and 32 passenger cars at a total cost of $18,000,000; the pur-
chase was financed through a cash payment of $4,500,000 ( 25%)
and the sale of $13,500,000 in 2&% trust certificates payable at the
rate of $900,000 annually for 15 years.
Under one method now used almost universally, known as the
Philadelphia plan, the equipment is leased to the road for the
period by a bank acting as trustee, the installment payments are
regarded as rent, and the investors receive "dividends" on their
equipment trust certificates. The certificates represent a beneficial
interest in the trust and are usually guaranteed as to principal
and interest by the railroad. The trustee leases the equipment to
the railroad at an annual rental sufficient to pay the expenses of
the trust, dividends on the certificates, and the principal of the
certificates as they mature serially. The railroad also agrees to
maintain the equipment in good order. The lease expires after
all the certificates have been paid, and at that time title to the
equipment is transferred to the railroad. In the event of default,
the trustee may take possession of the equipment and sell it for
the benefit of the certificate-holders.
Under another method, known as the New York plan, the
equipment is purchased from the trustee under a conditional bill
of sale whereby title immediately reverts to the trustee in the
event of default, and the investors receive "interest" on their
equipment trust notes.
Equipment trust obligations are usually regarded as excellent
investments and bear low yields, owing to: (1) the essential na-
ture of the equipment; (2) the quality of mobility that would
facilitate repossession and ready sale; (3) the gradual increase
in the value of the equity due to the liquidation of the debt on a
scale faster than the depreciation of the equipment, which nor-
mally lasts well beyond fifteen years; (4) the fact that receivers
and trustees in charge of companies in insolvency usually continue
to pay interest charges on equipment obligations even though
they may allow the mortgage bonds of the company to remain
in default; and (5) the excellent investment record of these se-
curities, as illustrated in the fact that in only one recent instance,
that of the Florida East Coast Railway, was the lease disaffirmed
and the equipment sold (1936). In this case payments totalling
$593.54 per $1,000 certificate were distributed. In three other
cases in the 1930's, maturities were extended and two roads ex-
changed their certificates for other obligations bearing a lower
rate of interest.
Receivers certificates are the obligations of a company being
operated by a receiver in equity. With proper court approval,
they enjoy priority over other obligations, although technically
they are not secured by any lien. They are issued as a means of
improving the property and the working capital position of the
failed company, pending a reorganization. Receivership in equity
has largely given way to reorganization under bankruptcy pro-
ceedings, and trustees' certificates are the modern equivalent of
the older receivers' certificates.
Refunding bonds are those issued for the more obvious purpose
of getting new capital on a favorable basis. Just as the conversion
of a short-term debt into a long-term debt is known as a "funding"
operation, the payment of debt at or before maturity with the
CHARACTERISTICS OF CORPORATE RONDS 63
proceeds of a new loan is called "refunding." The main reason for
refunding before maturity is to save on interest charges when
interest rates have fallen or the credit of the issuer has improved.
Refunding at maturity takes place when the company has made
no provision for redemption. The investor must examine a "refund-
ing" issue to determine whether or not the use of that name is for
the purpose of disguising a second mortgage.
Terminal bonds are issued for the purpose of financing the con-
struction of terminal facilities in large cities to be used by one
or more railroad companies. These companies, either separately
(severally) or collectively (jointly), usually assume proportionate
responsibility for the debt of the terminal company, either by
direct obligation or by guarantee. The companies which pro-
portionately guarantee the bonds of the Terminal Railroad Asso-
ciation of St. Louis include several of the most important systems
in the country. An interesting observation in connection with
terminal bonds is that companies in default on their mortgage
bonds are usually permitted by the courts to make their pro-
portionate payments on terminal contracts in order to retain the
use of an essential facility.
Titles based upon form of issue. Bonds are issued in either
coupon or registered form. Some, but not all, are interchange-
able for a small service fee. Coupon bonds are payable to bearer
and carry detachable' interest coupons. Registered bonds are
payable only to the registered owner, to whom interest checks
are mailed, except in the case of bonds registered as to principal
only. The coupon bond, being more negotiable to the bearer,
may be more conveniently transferred and hence often commands
a price slightly higher than that of the registered bond.
Interim bonds are temporary certificates issued pending the
preparation of the definitive bonds. Some months are required
for the preparation, engraving, and printing of the regular bonds.
In the meanwhile, the interim certificate evidences ownership
and may be as readily disposed of as the permanent bond. Tem-
porary receipts from investment dealers are not interim bonds,
however, and should be accepted for brief periods only.
Titles based upon redemption. In certain instances, the title
of a bond is taken from some feature with respect to redemption.
In such cases, the bond may be a secured or an unsecured obliga-
tion; if secured, the claim is usually a junior lien, since the com-
pany would naturally select a more indicative title for a senior
obligation.
Extended bonds are those on which the maturity date has been
extended under a mutual agreement with the bondholder. The
Stony Creek Railroad Co. Extended Gold 4's of 1957 were origi-
nally issued as 7's in 1872, but, at maturity in 1907, they were
extended to 1957 at a lower interest rate.
Gold bonds are those which are expressly payable in gold coin
of specified weight and fineness. Gold-payment clauses in domes-
tic obligations, both public and private, were abrogated through
Federal legislation on June 5,1933, with respect to past and future
contracts. Such action made the gold clause inoperative and there-
fore ineffectual for the designed purpose of protecting investors
against currency depreciation.
Perpetual bonds are those that represent permanent obligations
and might more properly be termed perpetual interest-bearing cer-
tificates, as in the case of the Columbia, Newberry and Laurens
Railroad 5% income certificates. Certain Lehigh Valley Railroad
Consolidated Mortgage bonds, which bore an original maturity
date of 1923, were converted, by mutual agreement, into per-
petual obligations and bore the title of Irredeemable until 1949,
when their maturity was set at 1989. The well-known British
Government "Consols" (an abbreviation of Consolidated) are
perpetual bonds. Some long-term domestic issues, such as the
West Shore Railroad 4's of 2361 and the Elmira and Williamsport
5's of 2862, might readily be classed as annuity bonds for all prac-
tical purposes.
Redeemable bonds, also known as callable, are those which
may be paid at the option of the issuer during a specified period
prior to maturity date. Most modern bonds contain this feature.
The price at which the bonds may be repaid is usually computed
on a sliding scale providing for a relatively high premium of as
much as $5 to $10 per $100 of principal in the event of early re-
demption and declining to zero just before maturity. From the
investor's viewpoint, it is unfortunate that the life of callable
bonds is uncertain and that they are most likely to be called when
interest rates are low. The buyer of a redeemable bond faces the
prospect of being forced to accept less income if interest rates fall
but of not being able to obtain more income if interest rates rise.
Since most bonds are callable, the investor has little choice in the
matter. And the call price acts as an upper peg or platform
through which the price of the bond is not likely to break except
in a very strong bond market and when the chances of call are
unlikely.
Serial bonds are those on which the maturities are spread over
a succession of years rather than in a single year. The Pennsyl-
vania Railroad Equipment 2%'s (series "Y") were isued in 1950
in the total amount of $20,820,000 repayable at the rate of $1,388,-
000 annually from 1951 to 1965. In interesting contrast to the
general practice of having all bonds in a serial issue carry the
same interest rate, the United States Steel Corporation brought
out a serial issue in 1940 on a semiannual basis from 1940 to
1955 with interest rates gradually increasing from % of 1 per cent
on the earliest maturity to 2.65 per cent on the bonds payable in
1955.1 Most municipal bonds are retired serially.
Series bonds are those that are issued in sequential series under
an open-end mortgage. Although all bonds thus issued have the
same security, each series has distinctive features such as interest
rate, maturity date, and call price. This type of financing gives
the corporation a maximum degree of flexibility and allows each
new issue to meet the prevailing conditions in the market. The
Commonwealth Edison (Chicago) First Mortgage Series "N"
bonds, brought out in 1948 with an interest rate of 3 per cent,
represented the fourteenth issue of bonds under this mortgage,
the first issue having been sold in 1923.
Sinking fund bonds are those that require the establishment of
a fund, to be built up during the life of the issue to sink, or liqui-
date, the debt. Such bonds are more prevalent in industrial issues
than in railroads or public utilities, although there is a growing
tendency, through the force of regulation, to insert sinking fund
requirements in these latter types. The amounts annually appro-
priated for the sinking fund may be: (1) fixed annual amounts
either a certain amount in dollars or a percentage of the bonds
1 This issue was the first serial maturity bond to be listed on the New York Stock
Exchange. Previous serial issues were not admitted because of probable confusion
in price quotations arising out of varying maturity dates on the same issue. The
U. S. Steel debentures were retired in 1944.
issued; or (2) varying annual amounts, increasing or decreasing
each year; or (3) an amount varying with earnings; or (4), in
the case of extractive industries, an amount proportionate to
physical output. The sinking fund may be used: (1) to redeem,
either by purchase in the open market or by call, outstanding
bonds of the same issue; or (2) for investments in other securities.
From the investor's viewpoint, the first method stated in each
case is preferable. The expression "subject to call for sinking fund
only" applies to bonds which are otherwise non-redeemable.
Bonds which are called are drawn by lot and must be surren-
dered if loss of interest is to be avoided. A frequent source of
irritation to investors is the return to them of unpaid interest
coupons which are deposited for collection six months after that
particular bond has been called for redemption for the sinking
fund. As corporations keep no record of the names of owners of
coupon bonds, there is no way of notification of redemption other
than by newspaper advertising. Such notices are often missed by
bondholders, although the bondholder can protect himself by
using bank or broker safekeeping service. In partial compensation
for the loss of interest and the trouble of reinvestment, the bonds
are called at a premium, although such premiums are usually
lower than those paid for ordinary refunding.
Sinking fund requirements are particularly important in the
bond issues of corporations with uncertain earnings and those
whose property is inevitably depleted or depreciated through
time, such as extractive and real estate companies.
Sinking funds should not be confused with so-called "capital
improvement" funds whereby a public utility is permitted to
substitute increased investment in property for definite retirement
of debt.
Titles based upon participation. Some bonds that carry income
payments directly or indirectly contingent upon the earnings of
the issuer bear a title reflecting that condition. As a general rule,
these bonds are unsecured debts and in many cases bear a distinct
resemblance to stocks.
Income bonds are those on which the payment of interest is con-
tingent upon the amount of current earnings and is not a man-
datory charge. They are generally secured bonds issued as part
of a reorganization plan under which bond interest charges are
"scaled down" to an amount within the reasonable capacity of
the enterprise. Income bonds have been used to a large extent
in connection with railroad reorganizations. The practice of com-
pletely replacing fixed-interest bonds with income bonds has also
been employed extensively in real estate reorganizations. The
payment of interest on income bonds is contingent upon and
proportionate to earnings available, up to a maximum rate. The
interest is often cumulative; that is, if not earned and paid in one
year, it must be paid later before any dividends may be declared.
But if the interest is earned, it must be paid, in contrast to the
dividends on preferred stock, which are contingent on earnings
and declaration. One difficulty is the possible difference of opinion
that may prevail as to whether the interest has been earned or not,
in spite of the definition of earnings contained in the indenture.
The real earnings of a company, after allowance for maintenance,
depreciation, and other items, can be a matter of controversy.'
The reputation which income (adjustment) bonds have gained
by having been associated with failure, together with their in-
herently weak characteristics, has prevented their use for raising
new capital. Their real nature is difficult to explain to investors,
and they lack the straightforward features of ordinary bonds or
preferred stock. Even the tax advantage enjoyed by the corpora-
tion arising from the fact that their interest, unlike preferred
dividends, is deductible for tax purposes has not led to their use
for ordinary financing except in rare cases.
Participating bonds are those that are entitled to share in the
net earnings of the company in addition to receiving interest in
full on a fixed-charge basis. A participating bond is an anomaly,
since it seems to combine stock income with bond safety. Very
few such bondsin fact, none of any important companiesare
now outstanding. The modern method of bond participation is
through the indirect procedure of conversion or stock-purchase
options.
Convertible bonds are those that may be exchanged for stock
at the option of the holder at a ratio and during the period stated
in the indenture. These bonds make a strong appeal to investors
who like a privileged opportunity to share in the future earnings
of those companies to which they loan money. The conversion
feature may extend over the entire life of the bond, as it does in
the case of Vanadium Corporation of America Debenture 33s's of
1965; or over a limited period during the early life of the bond,
as in the case of Phillips Petroleum Convertible Debenture 2%'s
of 1975, which lose their conversion privilege in 1960. The con-
version ratio may be par for par, one $1,000 bond for ten shares
of $100 par stock, or in any fixed ratio, usually expressed in terms
of a conversion price for the stock. The Consolidated Edison
(N. Y.) Convertible Debenture 3's of 1963 are convertible at $25
per share, which means that one $1,000 bond may be exchanged
for as many shares of stock as $25 is contained into $1,000, or 40
shares.
The peculiar advantage of convertible bonds over stock is that,
in a declining market, the bonds will not fall below their invest-
ment value as straight bonds, whereas the stock, not having that
intrinsic strength, may fall to an extremely low level. In an ad-
vancing market, the bonds will advance fully in proportion to the
stock after the conversion parity has been passed. The Consoli-
dated Edison Debentures referred to above were convertible at
$25 a share in 1951 at a time when the stock was selling at $30 a
share. The market value of the bonds was therefore $1,200 (120)
despite the fact that the First Mortgage 3's of 1972 were currently
around $1,000 (100).
Convertible bonds have a special appeal under present condi-
tions because of their possibilities for hedging against inflation.
The circumstances under which conversion is likely to take
place are explained in Chapter 17. It is worthy of note that, while
conversion is at the option of the bondholder, a corporation may
force conversion by exercising the right to call the bonds at a
price lower than the market value of the bond or of the stock into
which it is convertible.
Provided the investor does not pay too much for the privilege,
the convertible feature may have real advantages. The owner of
the convertible bond remains a creditor as long as he holds the
bond, with the prior position that creditor status provides; then
when it is to his advantage to do so, he may convert into stock
with its possibilities for higher earnings and price appreciation.
For this reason convertible securities are regarded as logical
"hedges" during a rising stock market. However, the investor
should remember that, once conversion has taken place, the step
cannot be retraced. Moreover, although he may choose not to
convert, or if it is never profitable for him to do so, he has none-
theless probably paid something for the conversion option that
he has not exercised.
Bonds with warrants are those that bear stock-purchase option
warrants giving the holder the privilege of buying a certain
number of shares of stock at a fixed price. The warrants may or
may not be detachable, and may be valid for a limited or an un-
limited period. The warrants attached to the A. B. Farquar Co.
Debenture 4%'s of 1962 were not detachable until exercised, and
gave the bearer the right to purchase up to March 1, 1957, 25
shares of common stock at $15 per share. The warrants attached
to the Indiana Steel Products Co. Debenture 5's of 1957 were
detachable and gave the bearer the right to purchase up to Dec.
31, 1950, 4 shares of common stock at prices increasing up to a
maximum of $10 per share. Although many warrants become
highly valuable during active stock markets, investors should
realize that in warrant bonds, as well as in convertible bonds, the
speculative feature has usually been added mainly to enhance the
marketability of issues that lack fundamental investment quality.
Stock-purchase option warrants are being used to an increasing
degree in connection with bonds issued in corporate reorganiza-
tions. The purpose of the warrants is to give bondholders who
have accepted a drastic reduction in interest payments an oppor-
tunity to share in any subsequent improvement in the earning
power of the enterprise.
The investment position of bonds. Bonds have traditionally
been regarded as the most conservative form of investment in
the country. To the investor who has complete freedom in the
choice of his commitments, they provide a combination of safety
and convenience surpassing that available in any alternative form
of investment. To the investing institution which, for reasons of
fiduciary safety, is restricted in the choice of securities, bonds
provide the most satisfactory medium of investment, as evidenced
in the billions of dollars carried by these institutions in bond-
holdings. Under current conditions institutions are the important
buyers of corporate bonds. Individuals find more attraction in
Savings Bonds and in tax-exempt municipals.
Yet no investor can afford to assume that just because a security
is a bond, it has inherent strength. Bonds vary greatly in invest-
ment quality from worthless to almost riskless. The investor would
do well to examine each security on its own merits, regardless
of its legal form. Generalizations concerning any large class of
securities are usually dangerous. Yet it is interesting to note that
in the capital markets the essential feature of bonds, namely, that
they represent debt, is indicated by the fact that the highest-grade
bonds always sell at lower yields than those prevailing on the
highest-grade ordinary preferred stocks. That some common stock
yields are lower than bond yields is not evidence of their superior
safety of income and principal but of the regard in which they
are held by investors who are looking for growth and apprecia-
tion rather than yield.
As to whether bonds are "better investments" than stocks, the
answer is that most bonds are safer insofar as dollars of interest
and principal are concerned. But whether a particular bond is an
appropriate investment depends on the bond and on the needs
and purposes of the investor.
CHAPTER 6
CHARACTERISTICS OF STOCKS
Scope. The purpose of this chapter is to discuss the character-
istics of stocks from the viewpoint of the investor. The order of
discussion is: (1) general characteristics, (2) legal position of the
stockholder, (3) stock terminology, (4) preferred stockgeneral
nature and types, (5) classified common stock, (6) preferred
stocks as investments, (7) guaranteed stocks, (8) common stock
nature and dividends, (9) common stocks as investmentsad-
vantages and disadvantages.
The form and title of a security do not determine its investment
quality. Many common stocks have had very superior records,
and many preferred stocks have become worthless. Nevertheless,
the basic distinctions are important, and some general conclusions
may be set forth concerning the relative attractiveness of the two
great classes of stocks. The reader will realize, however, that in
the case of any individual security, it is the earnings and dividend
record and prospects and the amount and character of the assets
that support the stock that determine its investment status.
General characteristics. In contrast to bonds, which represent
debt, capital stock represents the ownership of a corporation.
Stock, whether preferred or common, involves no promises. The
owner of a share of stock is part owner of the corporation. His
stock gives him the right to share in the net assets of the business
(if any), the net income (if any), and management.
The capital stock is divided into units, called shares. On Decem-
ber 31, 1950, the stock of J. C. Penney Company comprised 8,231,-
592 shares, each of which represented 1/8,231,592 share of the
net assets or net worth of the company. The evidence of owner-
ship of shares is the stock certificate. The name of the owner
appears on the face of the certificate, together with the number
and kind of shares represented by the certificate. The certificate
71
72 CHARACTERISTICS OF STOCKS
is always a registered instrument; the owner's name is registered
on the books of the company. Only the registered owner can
assign the stock by signing the blank form on the back of the
certificate. The registered owner is the one who receives the
dividends, has the right to vote, and otherwise enjoys the privi-
leges of ownership.
Stock certificates, being evidences of ownership rather than
debt, are not inherently negotiable. But they have been given
this status in the states that have adopted the Uniform Stock
Transfer Act. When stocks are sold, the usual practice is for the
owner to endorse them in blank. They may pass through many
hands before being registered on the corporation's books in the
name of the new owner. The actual registration and transfer is
usually handled by a transfer agent appointed by the company.
Corporate stock may have nominal par value, of from a few
cents to several hundred dollars per share, or no par value. The
par value is a purely nominal amount which is supposed to show
the original investment per share. When the par value has been
paid in to the corporation, the stock certificate is designated "full-
paid and nonassessable." For many years the customary par value
was $100. Today the trend is toward low-par value stock, or the
use of stock without par value, which is full-paid when the original
consideration set for each share has been received. Only in the
regulated industries, such as the steam railroads, the commercial
banks, and the public utility operating companies, do par stocks
predominate.
To the investor, no-par stock has a real advantage in that each
share simply represents a certain fractional ownership in the
corporation without any confusion as to nominal value. A stock
with a par value of $50 (Pennsylvania Railroad) may sell, as it
did in 1950, at $14 to $22 per share. It is likely that few of its
owners knew that at one time the company had received the
equivalent of $50 per share in cash or other assets for this stock.
Neither the market value nor the book value (dollars of net assets
per share of stock) is influenced by the nominal par value after
the company has been in operation for some time.
The following schedule shows the par value (if any), the book
or net asset value at the end of 1950, and the range in market
value of selected common stocks for the year 1950. While the
73
selection is not representative of all stocks, it does reveal the fact
that the market value, based primarily on the prospects for earn-
ings and dividends, is usually very considerably different from
nominal and book values.
"VALUES" OF STOCKS
Par Value,
Dec. 31,
1950
Book Value,
Dec. 31,
1950
Company
Price Range,
1950
$ .05
$ 22.41
554-1154
.10
2.68
1)4-3)4
.25
6.51
3-754
.50
20.91
11)4-18%
1.00
2.85
3)4-7)4
1.00
56.04
22-3755
3.00
14.80"
11)4-20
5.00
23.13
34)4-54%
10.00
57.97
15-25
New York & Harlem R.R. (guaran-
25.00
71.83
42)4-61%
teed )
50.00
25.73
201-246S
50.00
99.13
14)4-2251
100.00
222.89
17-33)4
First National Bank (N.Y.)
100.00
1,420.67
1195-1360
no par
80.20 00
49)4-67)4
no par
33.01
11254-165
As of June 30, 1950.
As of Jan. 31, 1951.
Legal position of the stockholder. Stockholders, as part pro-
74
management desires to reinvest the profits in the business. This
is true even of preferred stock, except that the preferred has a
right to dividends before the common.
The stockholder has the right to share in the net assets of the
corporation in the event of dissolution. This right vanishes in
practical value in the case of failed concerns, even in the case of
preferred stocks, which ordinarily have a set liquidating value
that must be paid before anything goes to the common. But where
there is nothing to distribute, such priority is meaningless.
The stockholder has a right to subscribe to new issues of stock
in proportion to his old holdings before such new stock may be
offered to outsiders. This pre-emptive right may be denied only
when so stated in the charter, but it is not ordinarily granted to
preferred stock. As these privileged subscriptions are generally
offered below the prevailing market price, this right is often valu-
able. The method of calculating the value of rights is given in
Chapter 17.
The stockholder has a right to inspect the corporate books.
This right applies to the general books, such as the minutes of the
stockholders' meetings and the list of stockholders, rather than
to the ledgers and the books of financial record, and is restricted
by certain requirements that make it of little value to the investor
unless he wishes to stage a proxy battle with management.
The stockholder has a right to vote in the selection of the board
of directors and on all matters affecting the corporate property
as a whole, such as sale or merger or liquidation of the business.
The voting privilege may be restricted to one class of stock or to
one group of stockholders.
Other fundamental rights of the stockholders include the right
to receive a certificate representing his shares, to transfer his
shares, and to take action against the wrongful acts of the man-
agement and the majority of stockholders.
The stockholder is liable for the debts of the corporation only
to the amount of unpaid subscriptions to the capital stock, and
to the difference between subscription price and par value, in the
event the former is lower. This limited liabilitv feature of cor-
porate stock, in contrast to the unlimited obligation that exists
in partnerships, is one of the great advantages afforded by the
corporate form of organization.
CHARACTERISTICS OF STOCKS 75
The stockholder is also generally liable for wages of employees
for limited periods. This provision applies to employees in sub-
ordinate positions, for periods not exceeding three months, under
somewhat technical conditions.
Stock terminology. The investor should be familiar with certain
terms associated with stock. The authorized stock is the maximum
number of shares of all types that may be issued, as specified in
the certificate of incorporation. To change this number, or the
provisions of any class of stock, requires the formal approval of
stockholders. Issued stock is the amount of shares that have been
issued for cash, property, or services. Stock reacquired by the
company by purchase and donation and not reissued or cancelled
is called treasury stock. Treasury stock is ordinarily deducted on
the balance sheet from the issued stock to show the amount of
outstanding stock. Full-paid stock is, as we have seen, stock for
which the corporation has received full payment up to par value,
or up to the amount established as the selling price of no-par
shares. Part-paid stock is stock that has been issued for less than
par value or the agreed subscription price. Under the laws of most
states, stock cannot be issued unless fully-paid.
Preferred stockgeneral nature. The capital stock of a com-
pany is often divided into two classes, one of which, usually
called preferred stock, has priorities over the other, usually called
common stock. The provisions of the preferred stock are set forth
in the corporate charter. The universal characteristic of preferred
stock is that it has priority over the common stock with respect
to dividends, since no dividends may be paid on the common
stock in any year in which the full preferred dividend has not
been paid. The amount of the annual dividend to which the pre-
ferred stock is entitled and to which it is limited is stated in the
charter of the company and on the stock certificates either in
dollars per share or as a percentage of par value. The preferred
dividend is not a fixed charge in the sense that the company is
required to declare it. It is not a claim. Preferred dividends, like
common dividends, are contingent upon the financial condition
of the company and the discretion of the management as repre-
sented by the board of directors. Even though the available
profits may be adequate for the payment and the cash position
may be strong, the directors may decide to conserve the funds
76
in the business rather than to pay out dividends. However, where
the preferred dividend is earned, there is a strong inducement to
pay it in order to keep the record clean and to keep the road clear
for common dividends.
Cumulative preferred stock is that type under which dividend
payments omitted at any time accumulate in the form of arrear-
ages. These arrearages must be paid in full before any dividend
payments may be made on the common stock of the company.
Noncumulative preferred stock is the other type which has no
prior claim on dividends, except on those for the current year.
Past dividends are lost forever. The advantage of cumulative over
noncumulative preferred stock is not so great as it might seem.
A prolonged period of poor earnings may result in an accumula-
tion of dividend arrearages beyond the capacity of the company
to pay. A situation is thereby created wherein a solvent company
is almost permanently enjoined from paying any dividends to the
common stockholders. Even when the amount of arrearage is not
discouragingly large, the holder of cumulative preferred stock is
usually persuaded to accept other securities or part cash in lieu
of cash in full.
Some companies have adopted a practice of issuing different
classes of preferred stock which may share the same rank of
priority or which may have varying priorities. Pacific Gas and
Electric Company has six classes of preferred stock, all ranking
equally in priority but having dividend rates ranging from 4.8 to
6 per cent (on $25 par). The Mead Corporation has two classes,
one of which carrying the rate of 4& per cent is known as Pre-
ferred and has dividend priority over the second, known as Second
Preferred and carrying a rate of 4 per cent. The term prior pre-
ferred is sometimes used to designate the particular preferred
stock which has priority of claim, although the term first preferred
is more generally used for this purpose. In such cases, the senior
issue is entitled to its full dividend rate before any payment may
be made on the junior issue.
Preferred stocks usually have priorities in the distribution of
assets (in the event of dissolution) as well as in the distribution
of profits. The amount of such preference is usually stated in
dollars per share and generally approximates the original value
of the stock, plus any accumulated dividends. This "preference
77
as to assets" is rarely of practical value. Most companies dissolve
as the result of failure, a condition which usually finds the credi-
tors in possession of the assets, with little if anything available
to the stockholders.
Redeemable or callable preferred stock is stock which may be
retired by the issuing company upon the payment of a definite
price stated in the instrument. Although the call price provides
for the payment of a premium, which may be as much as $25
above the face value of the stock, the provision is more advan-
tageous to the corporation than to the investor. When money
rates decline, the corporation is likely to call in its preferred stock
and refinance it at a lower dividend rate. When money rates rise,
the value of the preferred declines so as to produce a higher yield.
And the call price tends to act as an upper peg or plateau through
which the price will break only in a very strong market. Several
instances might be cited at the time of writing where nonredeem-
able preferred issues are selling at prices far above the prices of
comparable redeemable preferred issues. Although a call price
of $120 could readily hold down the market price of a $7 Pre-
ferred stock, the thought that a similar call price could limit the
market price of a $5 Preferred stock probably never occurred to
the management of General Motors when that issue was origi-
nated. In July, 1951, this preferred stock sold at 123 to yield 4.06
per cent. The $3.75 preferred stock of the same company, callable
at 105, sold at 99 to yield 3.79 per cent.
Convertible preferred stock is that type which may be ex-
changed into common stock at the option of the holder. Preferred
stocks which carry this privilege are likely to be deficient in
quality, because it is rarely necessary that this feature be included
in order to attract investment buyers. The exchange ratio is stated
in the instrument and, under modern practice, is on a sliding scale
whereby the conversion price increases during the conversion
period. A large industrial company has issued convertible pre-
ferred stock on which the conversion price, which is now $50 a
share, will increase to $66% in 1952 and $75 in 1954, which prices
indicate that, respectively, 2 shares, VA shares, and V/3 shares of
common stock will be exchanged for 1 share of preferred stock.
The convertible feature may have real appeal to investors who
are looking for a compromise type of security. The circumstances
under which conversion becomes profitable are discussed in Chap-
ter 17. Further discussion of convertible securities is also found
in Chapter 5 under the heading "convertible bonds."
Participating preferred stock is that type which is entitled to a
further share in any dividends after the payment of the regular
preferred dividend. There are many different participating ar-
rangements, but the one most frequently found permits the pre-
ferred to share with the common stock in further dividend dis-
tributions after the common has received a stated rate. Very few
important preferred stocks contain the participating feature. It
is usually regarded as a speculative inducement used to bolster
the attractiveness of a preferred stock that lacks strength on its
own merits. The same is true of preferred stock to which stock-
purchase warrants are attached at the time of sale. These war-
rants, which give the owner the right to purchase common stock
from the company at a stipulated price during a specified period,
are usually a substitute for sound investment quality in the pre-
ferred stock itself.
Preferred stock protective provisions and voting rights. In addi-
tion to the two basic features of preferred stock noted previously
preference (over the common stock) as to dividends and as to
assetsit is not unusual to find other features designed to give
the preferred stock investment strength. These are especially im-
portant in the case of preferred stock that lacks ordinary voting
rights. The more important are: (1) a repurchase or sinking fund
provision that requires the steady reduction in the amount of
preferred outstanding; (2) a provision requiring the approval by
the preferred stockholders of the issuance of any funded debt or
of additional preferred; (3) a provision restricting the payment
of common dividends unless a certain working capital position is
maintained.
While the right to vote for the board of directors and thus par-
ticipate in management is a fundamental right adhering to all
stock, it is often withheld from preferred stock. No great harm is
done so long as the company's earnings, dividends, and general
financial strength are well maintained. The investor in preferred
stock, although a part owner of the corporation, regards himself
as an "outside" investor. However, if dividends are not paid, and
if he has no voice in management, he is in an impotent position.
79
It is customary, therefore, to reserve for the preferred the right
to vote under certain conditions, even if normal voting power is
lacking. The preferred may be given one vote per share after a
certain number of quarterly dividends (often four or six) have
been omitted. Or the preferred as a class may receive the right
to elect a certain number of directors, or, in some cases, to elect
a majority or even all of the directors. Such contingent voting
power of the preferred is a strong inducement to management to
earn and pay the preferred dividends and avoid an accumulation.
In addition, the preferred usually has the right to vote on certain
questions that affect its status considerably, such as on the disso-
lution of the company, the mortgaging or sale of its property, and
merger with another concern.
Classified common stock. In the 1920s, a hybrid type of security
was developed by the issuance of more than one type of "com-
mon" stock, and today the balance sheets of many corporations
show "Class A" and "Class B" common, or "Class A common" and
"Common." In some cases, for example, in the great tobacco com-
panies, the only difference between the two classes of common
is that one is devoid of voting rights. Control of the corporation
is thus concentrated in one issue. In recent years there has been
a movement away from non-voting common. It may not be listed
on the New York Stock Exchange and it is frowned upon by the
Securities Exchange Commission insofar as gas and electric com-
panies are concerned.
Other issues of so-called classified common stock are, in fact,
mere weak preferred stocks, with preference as to assets and
dividends but without the other protective provisions ordinarily
found in true preferred. The investor owes it to himself to discover
the provisions of any classified common stock in which he may be
interested. A description of such provisions is readily obtained in
the investment manuals.
Preferred stocks as investments. Preferred stock occupies an
intermediate investment position, offering more income but less
safety than bonds, and less income but more safety than common
stocks. Admittedly a compromise security, it is designed to attract
investors who desire what might be called a favorable rate of re-
turn and who are willing to assume the attendant risk. Some pre-
ferred stocks resemble bonds in their investment position but
80
many preferred issues might more properly be placed in the cate-
gory of common stocks as far as investment quality is concerned.
Some preferred stocks might appear to belong in the bond
category because of their technical position. Certain companies,
such as International Harvester, Eastman Kodak, General Motors,
and American Smelting and Refining, have no bonds outstanding.
Consequently, the preferred stocks of these companies have
claims on earnings which are not subordinate to or lessened by
bond interest payments. So long as this condition continues, these
preferred stocks are the senior securities of the enterprise. Never-
theless, they consistently sell at higher yields than high-grade
bonds in recognition of their position as equities.
Other preferred stocks belong in the bond category because
of the prosperity of the issuing companies. Certain railroad com-
panies, such as Union Pacific and Norfolk and Western, certain
public utility companies, such as Cleveland Electric and Pacific
Telephone, and certain industrial companies, such as National
Biscuit and Corn Products, have established impressive records
of earnings over long periods of years, thus placing their preferred
stocks in a strong investment position. Included in this group are
many rather small public utility operating companies which have
unbroken dividend records on preferred stocks running back many
years.
A great many preferred stocks, especially those of utility hold-
ing companies and of industrial companies, are, however, in the
common stock category because of inadequate earnings protec-
tion. In too many instances, investors have bought preferred
stocks upon the apparent assumption that the payment of divi-
dends was no less certain than the payment of interest on bonds.
They have found that the preferred dividends may be passed and
that in liquidation or in reorganization the preferred stockholders
are in a weak bargaining position.
There are some very high-grade preferred stocks, and too many
of low-grade quality. The investor should realize that it is not
the form of a security that gives it value and stability, but the
earnings and assets that support it. Nevertheless, the fact that
preferred stock lacks the legal claim of the bondholder and the
profit and appreciation possibilities of a common stockholder
(because of the customary fixed dividend rate, stated liquidating
81
value, and call feature) gives it a questionable investment status
that is clearly revealed when hard times appear. Perhaps this ex-
plains the fact that even the highest-grade preferred issues, pro-
tected many times over by assets and earning power, always yield
more than high-grade bonds of long maturity.
Guaranteed stocks. Guaranteed stocks are those upon which
dividend payments are guaranteed by some company other than
the issuer. Obviously, no company can guarantee dividends on its
own stock. The guarantee usually arises out of a consolidation of
properties under a lease. Such stocks, confined almost entirely to
the railroad field, may be preferred or common. Guaranteed stocks
partake more of the nature of bonds, since dividend payments are
fixed, rather than contingent, charges. The amount of the guaran-
teed dividend is either the regular rate stated on the preferred
certificate or a contractual rate agreed upon in the case of com-
mon stock.
The investment position of guaranteed stock depends upon the
nature of the guarantee, the value of the underlying property to
the guaranteeing company, and the financial responsibility of the
guaranteeing company, but most especially the latter. The ideal
guaranteed stock would be one protected by an unqualified
guarantee of a definite dividend rate under a long-term lease con-
tract, covering property of strategic value to a prosperous guaran-
teeing company. Such a security is to be found in the case of the
common stock of the United New Jersey Railroad and Canal Com-
pany, which forms ,part of the main line between New York and
Philadelphia of the guaranteeing Pennsylvania Railroad. The
common stock of the New York and Harlem Railroad is highly
rated, more because of its underlying value in providing terminal
facilities to the New York Central Railroad than because of the
credit position of the guaranteeing company. It is significant to
observe that not even the receivership of the guaranteeing com-
pany necessarily means a breach of the guarantee. During the
receivership of the old Chicago and Alton Railroad, dividends on
the guaranteed Joliet and Chicago common stock were paid regu-
larly although no interest was being paid on the Chicago and
Alton bonds. A further favorable factor in connection with guaran-
teed preferred stocks is that they are seldom redeemable.
A notable example of a strong guaranteed stock is shown in the
case of Pittsburgh, Fort Wayne and Chicago Preferred, which
not only is secured by valuable underlying property (being on the
main line from Pittsburgh to Chicago) and by a large guaran-
teeing company (the Pennsylvania) under a long lease, but also
has first claim on the property because of the absence of prior
indebtedness.
Common stock. Common stock represents the basic ownership
of the company. The claim of the common stockholders to income
and assets is subordinate to all other claims, except in the rela-
tively few instances where preferred stock is not preferred as to
assets. Ordinary common stock always has voting rights. Common
stocks are often called equities, since they usually represent only
part of the total capitalization as contributed by the owners, in
contrast to the remainder supplied by the creditors. In some in-
stances, the common stock comprises the sole security issued by
the company, as notably illustrated in the cases of Wrigley, Gen-
eral Electric, and United Fruit. The common stocks of such com-
panies enjoy a fundamentally sound position that is rarely met
in equity investments.
After a corporate reorganization, the shares of the new company
are often placed in trust with a small group of trustees for from
five to ten years. Voting trust certificates are issued to the stock-
holders. These certificates have all of the characteristics of the
common stock itself except voting rights.
Income payments to stockholders are made in the form of
dividends, which, as the term implies, represent a division of
profits. Dividend payments are usually made quarterly and are
payable in cash.1 The payments may be made semiannually or
annually, and are occasionally in some form other than cash. In
some instances, dividends are declared in the form of short-term
promissory notes, called scrip. In rare cases, certain of the cor-
porate assets are distributed as property dividends.
1 During recent years, the American Telephone and Telegraph Company has
paid a cash dividend on the fifteenth of January, April, July, and October to all
stockholders who were listed on the corporate books on the twentieth of the pre-
ceding month. The interval between the "record date" and the "dividend date" is
provided in order to allow the checks to be prepared for mailing. The magnitude
of this task is indicated by the fact that more than 1,000,000 separate stockholders
receive checks quarterly from this one company. A mailing schedule is prepared
under which all stockholders throughout the country receive their checks at the
same time, irrespective of place of residence.
83
Investors are often confused by dividends in the form of stock,
since the distribution is in reality a matter of dividing the owner-
ship into a large number of units, and, therefore, not a true dis-
tribution of earnings. While this assumption is correct, the result
would not be different if the disbursement were made in cash and
the money reinvested in new stock offered by the company. Stock
dividends are the external evidence of internal reinvestment of
profits in the business. Stockholders who do not desire to increase
their investment in the company should sell their stock dividends.
In doing so, of course, they are parting with a portion of their
equity in the company.
Dividend policies. Investors in common stocks should become
acquainted with the dividend policy of any company in which
they are interested. Corporations usually adopt a certain policy
which characterizes their dividend distributions for long periods
of time. These policies may be divided somewhat arbitrarily in
the following fashion:
Regular dividend irrespective of current earnings. This policy,
as followed by the American Telephone and Telegraph Company
for many years, is regarded as the investment ideal. The only
disadvantage is that the dividend rate may be maintained too
long after earning power has declined, as illustrated in the classi-
cal example of the New Haven Railroad in the early years of the
present century.2
Regular dividend proportionate to current earnings. The policy
of distributing substantially all earnings in dividends is followed
by operating utility companies and by industrials not seeking to
expand, as in the case of Cream of Wheat.
Regular dividend at minimum rate. This policy permits com-
panies to pay a small but dependable dividend at all times and to
reinvest most of current earnings for expansion purposes. This
policy is characteristic of Amerada Petroleum and man^ other
companies in the petroleum industry, and forms the basis for oc-
casional extra distributions, usually in the form of stock.
Regular dividend payable in stock. This policy enables com-
2 The establishment of an impressive dividend record is not necessarily indicative
of an equally impressive record of earnings. During the twelve-year period from
1927 through 1938, the Pullman Company paid dividends aggregating $128,500,-
000 in contrast to aggregate net profits of only $80,400,000 during the same period.
84
panies to make a distribution to stockholders which they may
convert into cash if they desire, but which allows the retention of
profits in the business. A current example is found in the case of
Publicker Industries.
Regular dividend payable partly in cash and partly in stock.
This policy, which represents a combination of two methods, is
used by a few companies. In such cases, the cash payments are
made quarterly, but the stock payments are made either semi-
annually or annually to avoid the effect of rapid compounding.
An example of such a policy is found in International Business
Machines.
Experience has taught corporate stockholders two important
considerations respecting dividends. The first is that common
stockholders should not expect to receive all or even the major
part of available earnings as dividends. The management is almost
certain to retain part of the profits in the business, a policy that
has been especially in evidence since World War II.
The following schedule shows the earnings and dividends per
share on the Dow-Jones average of 30 industrial stocks.3 While
not representative of all corporations, the data indicate the recent
tendency to retain more earnings than in earlier years.
Dividends as %
Earnings Dividends of Earnings
1940 $10.92 $ 7.06 64%
1941 11.64 7.59 65
1942 9.22 6.40 69
1943 9.74 6.30 65
1944 10.07 6.57 65
1945 10.56 6.69 63
1946 13.63 7.50 55
1947 18.80 9.21 49
1948 23.07 11.50 50
1949 23.54 12.79 54
1950 30.43 16.13 53
The chief reason for the conservative dividend policy followed
by many companies in recent years has been the purpose of rais-
ing funds for rehabilitation and expansion. In addition to short-
term borrowing for working capital purposes, three major sources
of long-term funds have been available: (1) long-term loans, as
represented by bond issues and term loans; (2) the sale of stock;
8 Source: Barron's Publishing Company, The Dow-Jones Averages.
85
and (3) the retention of earnings, as represented by depreciation
reserves and by reinvested profits. The use of the second of these
sources is often handicapped by the low prices of common stocks
in relation to earnings and assets. To sell stock at less than book
value may result in a considerable dilution of the existing stock-
holders' equity. To sell stock for a price that is a low multiple of
earnings, say five, imposes the requirement that 20 per cent
must be earned on the new investment to avoid diluting the
earnings on the existing stock. Many corporations have therefore
turned to retention of profits as a major source of funds, and their
dividend payments have suffered as a result. Such a policy makes
for a more conservative capital structure, but it may have a cor-
responding disadvantage in that the value of the retained earn-
ings, as represented by a growing surplus account, may not be
reflected in an equal growth in market price. In other words, the
reinvestment of surplus earnings is not always preferable to their
distribution in dividends from the point of view of the stock-
holder.
Another important consideration is that stockholders should
not rely upon accumulated surplus reserves to carry dividends
through poor years. Despite the almost universal belief that one
of the chief reasons for partial distribution of earnings is the crea-
tion of a reserve for dividends in lean years, recent experience has
clearly demonstrated the fallacy of reliance upon such considera-
tion. Numerous examples might be cited to evidence this state-
ment. Even the existence of a special reserve for this purpose
(American Car and Foundry) may not protect stockholders
against dividend reductions in poor years. Corporate management
has clearly indicated a reluctance to pay dividends in excess of
current earnings over any extended period in order that the cash
position may not become impaired.
Advantages of common stocks as investments. While it is
usually dangerous to generalize about the investment qualifica-
tions of any group of securities as a class, because of the wide
variation in quality within any one group, certain observations
concerning common stocks as investments may be hazarded.
The extreme depression of the early 1930's created a revulsion
of feeling toward common stocks that caused many investors to
revert to the traditional viewpoint that only bonds should be
86
bought for investment. Recent years have seen this attitude chal-
lenged by a growing interest in common stocks, not only on the
part of individual investors, but by institutional investors as well.
This is well illustrated by the change in the trust laws of New
York State in 1950 permitting the purchase of stocks for trusts in
those funds not restricted to the official legal list. Studies are
available to show that, given proper selection and timing, the
long-run record of a diversified list of high-grade common stocks
may be better than that of bonds from the standpoint of income
and capital value.4 The period selected and the securities making
up any such studies have, of course, greatly affected the results
obtained.
The increased popularity of common stocks is due in part to
contributory developments in the bond market. In the first place,
the rate of return which bonds afford has declined to such a low
level as to discourage investors who prefer, under such condi-
tions, to assume the higher risks in order to receive the larger
income that stocks return. The following table shows the average
annual yield of Standard and Poor's Composite 90 stock index
compared with same service's index of high-grade bond yields
and high-grade preferred stock yields.
High-Grade High-Grade
Corporation Preferred Composite 90
Bonds Stocks Common Stocks
1940 2.92% 4.14% 5.54%
1941 2.84 4.08 6.68
1942 2.85 4.31 7.20
1943 2.80 4.06 4.97
1944 2.78 3.99 4.89
1945 2.61 3.70 4.26
1946 2.51 3.53 3.98
1947 2.58 3.79 5.00
1948 2.80 4.15 5.53
1949 2.64 3.97 6.64
1950 2.59 3.85 6.58
In the second place, many large companies have substantially
reduced their bonded debt during recent years and have thereby
created a distinct scarcity of high-grade bonds. In the third place,
an important group of companies, such as General Electric and
1 The first of these was Edgar L. Smith, Common Stocks as Long-Term Invest-
ments (New York: The Macmillan Co., 1924). See also C. C. Bosland, The Com-
mon Stock Theory of Investment (New York: Ronald Press Co., 1937).
87
Standard Oil of California, have only common stock outstanding,
thereby compelling prospective investors in those enterprises to
buy common stocks if they desire to participate.
The increased popularity of common stocks, however, is not
due entirely to the changed status of bonds. There have been
positive as well as negative advantages. The redemption in whole
or in part of corporate indebtedness has reduced the burden of
fixed interest charges and thereby enhanced the position of the
stock. The rate of dividend return is not only more favorable than
interest yields but also is often backed by ample margins of safety
over sustained periods. The prospect of higher living costs arising
out of higher prices due to inflationary influences makes stock
ownership a possible "hedge" against the decline in the purchasing
power of money, a condition under which the bondholder is
distinctly vulnerable. Very potent also in the appeal of common
stocks to the average investor is the potential profit which may
come from appreciation in market value, especially in the so-
called "growth stocks."
Disadvantages of common stocks. The prospective buyer can-
not afford to overlook the distinct disadvantages involved in such
commitments, although again it must be emphasized that the
vast range in quality within the common stocks available for in-
vestment makes such generalizations somewhat dangerous.
From a technical viewpoint, common stocks suffer the double
handicap of being junior securities and of having only contingent
claims upon earnings. Any argument which might be used to
demonstrate the safety of common stocks must necessarily be an
even stronger argument in favor of bonds, since bonds invariably
have a prior claim on earnings. Furthermore, the stockholder faces
the probability of a reduction in income and the possibility of a
complete loss thereof in periods of economic stress, in contrast
to the contractual right of the bondholder to be paid irrespective
of prevailing earnings. This is not to say, of course, that all com-
mon stocks behave worse than all bonds in times of adversity.
From an economic viewpoint, common stocks suffer the double
handicap of being subject, in varying degree, to the vicissitudes
of the business cycle and to the adverse influences of industrial
trends. In periods of prosperity, when earnings are good, divi-
dends are regular and the situation is favorable; but in periods of
88
depression, when earnings are poor, dividends may be irregular,
and the situation of the stockholder is unenviable. Over longer
periods, certain industries grow as others decline, making the
selection of an industry as difficult as that of a particular corpora-
tion. A policy of alertness and adaptability is essential to protect
capital investments under these changing circumstances.
From a political viewpoint, common stocks suffer the handicap
of bearing the brunt of public regulation and increased and
double taxation (on both the corporate net income and the divi-
dends received by the investor). Even though the enterprise may
not be under the restricting influence of a regulatory commission,
as the railroad and utility companies are, the company may face
increased costs in the form of heavy taxes and higher wage scales,
which cannot all be passed on to buyers of their products and
which reduce income available to stockholders without, inci-
dentally, decreasing interest payment due to bondholders.
Finally, and most important of all, the erratic and unpredictable
action of the prices of common stocks that reflects the greater
risk of equities both in individual situations and in the market
as a whole makes the problem of valuation of these securities
particularly difficult. Too much may be paid for even a good
equity, and too little received for it when sold.
Nevertheless, in spite of their weaknesses, common stocks have
a place in the portfolios of many investors, provided: (1) the risk
is lessened by adequate diversification of industries and com-
panies; (2) all but the most skilled investors restrict their
purchases to the stocks of large, prominent, and conservatively
financed companies with a long record of continuous dividends;
(3) the prices paid for the stocks are reasonable in relation to the
average earning power of the companies selected; (4) the pur-
chases (and sales when sales are called for) are timed properly;
and (5) most important of all, provided the investor is in a posi-
tion to take the risks that even a well-diversified, well-selected,
well-timed portfolio of common stocks inevitably involves. Con-
siderable attention will be given to these problems in other sec-
tions of this book.
The final comment may be made that the vast majority of in-
vestors would do well to avoid attempting to "play the market"
in short-term trades, and that a great many of them would do
89
well to avoid the direct purchase of common stocks for long-term
holdings. Fortunately there are methods of indirect investment in
common stocks that make it possible to capitalize to a certain
extent on their real advantages and minimize, to some degree at
least, their equally real disadvantages. These are discussed else-
where in this volume.
(9)
(U)
(10)
(7-8)
PART III
TRUSTS
POLICIES
PRINCIPLES
BANK TYPES
INVESTMENT
INVESTMENT
INDIVIDUALS
MANAGEMENT
LIFE INSURANCE
INVESTMENT POLICY
CHAPTER 7
INVESTMENT PRINCIPLES
Scope. The purpose of Chapters 7 and 8 is to outline the general
principles that govern the investment policies of individuals and
institutions. Because of the wide variety of investment needs and
situations, the treatment must be very general. The more specific
application of the principles to institutional investment programs
is found in Chapters 9 and 10, and to individuals in Chapter 11.
The order of discussion in Chapter 7 is: (1) outline of steps in
framing an investment program, (2) determination of investor
goals and objectives, (3) investment requirements or considera-
tions, (4) types of investment risk: faulty initial selection, de-
terioration in quality, risk of cyclical change, risk of changing
money rates, and risk of changing purchasing power.
Steps in investment planning. The development of a family's or
an institution's investment program involves six steps, which are,
unfortunately, often approached in reverse order: (1) determi-
nation of investment goals in the order of their priority; (2)
recognition of the investment requirements that must be con-
sidered if the goals or objectives are to be fulfilled; (3) appraisal
of the various types of risks that threaten the meeting of these
requirements; (4) allocation of the available funds to the general
types of investment media in such a way as to meet the require-
ments and avoid or minimize the risks; (5) selection and timing
of specific investments; (6) continuous management and super-
vision. If this approach appears complicated, it is because in many
situations the problem itself is complicated and requires intensive
study and careful action. It is better to en- on the side of careful
analysis than to hazard the hard-earned savings of a family or the
funds entrusted to a savings or investment institution that repre-
sent the accumulations of thousands of individuals.
This and the succeeding chapter will deal with the first four of
93
94
these topics. The selection of specific investments comprises the
subject matter of the latter part of this volume.
Determination of investment objectives. The goals toward
which investment is directed will color the whole program. No
investment, however "safe" it may be with respect to income and
principal, is a "good" investment unless it fits the purposes of the
investor and helps to achieve the goals that are appropriate for
the investor. For example, a very wealthy individual whose whole
estate consists of Treasury bonds would be making a "safe" in-
vestment if he purchased additional short-term Treasury bonds
with new funds. Such a policy might not be "good," however,
because this investor is in a position to take advantage of the tax-
exempt features of municipal bonds, to take the risks attendant
to the carrying of equities, and to direct at least a portion of his
funds toward the goal of capital appreciation and preservation of
purchasing power. The purchase of additional Treasury bonds
would not be intelligent unless for some reason he needed a high
degree of liquidity and was content with a relatively low rate of
return. At the opposite extreme, the investor of limited means
with dependents to provide for and whose funds are already
wholly invested in common stocks might make a relatively safe
investment (as stocks go) if he purchased additional shares of a
strong, prosperous industrial corporation enjoying regular earn-
ings and paying regular dividends; but such a policy would not
be good because it might hazard his need for recovery of principal
and for highly dependable income, and he would be incurring
risks that he is in no position to take.
Whether a certain investment is good or not depends, then, on
the circumstances of the investor or investing institution, on the
goals toward which savings or institutional funds should be ap-
plied, in order of their relative importance, and on the risks that
can be assumed. A discussion of the various goals of institutional
investors is contained in Chapters 9 and 10, while the investment
objectives of individuals are set forth in Chapter 11.
Investment requirements or considerations. The factors that
modify the investment requirements and policies to fit the indi-
vidual needs and circumstances of a myriad of investors are too
numerous to mention, although some will be indicated in the
later chapters on investment of individuals and institutions. At
INVESTMENT PRINCIPLES 95
this stage in our discussion it is more feasible to consider the
general requirements that have to be considered by the whole
group, noting that the relative importance of these requirements
differs according to the needs and purposes of the investor. The
following list is not comprehensive and is not necessarily arranged
in order of relative importance, although it is likely that the first
factors mentioned are more important to most investors than are
the last.
1. Preservation and recovery of principal. For the vast majority
of investors the protection of the dollar value of investments is of
prime importance. In the case of savings accounts, no risk of loss
of principal is involved provided the savings institution remains
solvent and financially liquid. In the case of securities, the prin-
cipal may be recovered through resale only if the instrument is
readily marketable and enjoys relative price stability; securities
with a fixed maturity provide recovery of principal at maturity,
except in case of default. Temporary recovery of at least part of
the principal may be obtained through loans.
Emergency funds require complete liquidity, but this is achieved
only at the sacrifice of income. The same is true of the obligations
of institutions to meet payments on demand or on very short
notice. Funds accumulated by an individual as protection against
the death of the income-producer require liquidity in event of
death. In the absence of a substantial estate in fairly liquid form,
such a goal can be achieved only through the medium of insur-
ance. Funds accumulated for eventual home ownership must
likewise be protected against shrinkage, assuming that this goal
is important and that little risk can be taken in its fulfilment, and
the media chosen must provide complete assurance of funds, de-
pending on the timing of the purchase. Purchase of a home on
a long-term amortized plan, of course, avoids the problem of
accumulation of cash or investment in securities for this purpose.
'. investments made for purposes such as education of dependents
require considerable safety and possibly complete liquidity, de-
pending on the time of the need for such funds. In most situations,
the investor will be unwilling to risk the dollars saved for such
an important objective if it is immediate. Funds to be accumulated
for this purpose over a considerable period of time need not be
immediately recoverable, and more risk can be taken with them;
96
however, the amount of such risk will depend on the relative
significance of the objective compared with other goals. Funds
devoted to produce supplemental income for the individual in-
vestor before his retirement can be so invested by some families
as to risk change in market value, provided the income produced
is satisfactory. It is difficult to generalize concerning the relative
importance of preservation of dollar value for this purpose, since
the dependence on savings and income differs so greatly from case
to case. The same is true of investing for retirement. In some
cases, where the funds are small and the need urgent, little or no
risk can be assumed. Generally speaking, the smaller the fund,
the safer it must be, in terms of dollars, even at the expense of
income.
The creation of an eventual estate (other than through insur-
ance) is impelled by a wide variety of reasons. The estate may
have to provide for dependents, or it may be planned as a gift to
endowed or charitable institutions or for many other purposes. In
many cases, however, immediate liquidity is not required and,
provided previous goals have been satisfied, investments that are
subject to considerable price fluctuation may be undertaken.
The above very sketchy account of only a few of many different
situations suggests that the need of preservation and recovery of
principal depends on (1) the objectives of the investor and (2)
the degree of risk that can be assumed.
2. Assurance of income. For many investors this requirement
has equal or even greater importance than recovery of principal.
Except in the cases where total income is already very large in
relation to need, or where income from sources other than invest-
ments is very substantial, or where capital appreciation and tax
considerations are important, the factor of assurance of income is
likely to take a senior place in the priority of investment con-
siderations.
Whether or not the dollars of income from investments will be
assured depends, of course, on the solvency and earning power of
the user to whom the funds are committed and, in the case of
corporate stocks, on the dividend policy of the management.
Methods of determining these factors comprise much of the ma-
terial of this book. But the calculation of the need of assured in-
come is made prior to the selection of the investments that are
97
expected to produce it. The use of a few of the same general situa-
tions that were discussed in connection with the factor of safety
of principal will illustrate this point. Emergency funds that must
be available on short notice can produce little or possibly no
income, as in the case of bank deposits or savings bonds cashed
well before maturity. In the case of loans based on the cash-
surrender value of insurance, the income is likely to be negative
in that the rate charged on the loan will exceed the return pro-
duced on the insurance company's reserves. Savings accumulated
in various savings institutions and through the purchase of savings
bonds produce such a low rate that complete assurance of in-
come, preferably regularly compounded, is necessary to build up
the fund or produce the rock-bottom returns that such funds are
expected to provide. In the case of many investors, income at a
minimum of risk is needed immediately and continuously; in
other cases, such as for retirement purposes, it will be needed in
the possibly remote future, but funds to produce it must be built
up on the basis of a modest but certain rate of return. Generally
speaking, the smaller the fund and the greater the importance of
each dollar of income, the less the risk that can be assumed and
the lower the rate of income that can be obtained with required
safety. The small investor cannot have liquidity, assurance of
income, generous returns, and protection against rising prices
through the same investments. If assurance of income is para-
mount, other features must be sacrificed. The same is true for
most institutional investors. In other situations, however, regu-
larity and certainty of income may be much less important than
capital preservation and appreciation, tax savings, or protection
against inflation.
The preceding discussion assumes that by "income" is meant
regularly received income in the form of interest or dividends.
It is also possible to include in the concept of income the capital
appreciation that may be derived from the increase in market
value of equities. Some rapidly growing corporations distribute
only a very modest proportion of their earnings in dividends, and
the bulk of such earnings can be obtained only by resale, if the
price reflects such reinvestment. Such a concept of income is
perfectly legitimate provided the source of appreciation is the
profitable reinvestment of earnings and not merely a temporary
98
rise in market values due to temporary changes in the outlook for
the corporation or a cyclical rise in the price of its stock or in the
market as a whole. To rely on the latter types of appreciation,
while important and appropriate for some investors, is to tread
the narrow line between investment and speculation and prob-
ably to step over it. Much impetus to the choice of capital gains
as against income in the traditional sense has been given by the
special limits to taxes on such gains. Such a transfer of emphasis
from present income to future income and hence to future appre-
ciation is appropriate only for investors who do not need assured
current income and who can afford the risks that buying and
holding for appreciation involve. The important thing is that the
risks be recognized and that the selection and timing of the pur-
chases and sales be made intelligently and at prices that do not
over-value present assets and income and future prospects.
3. Freedom from management. There are many investors whose
commitments must be as care-free as possible, either in the sense
that safety of principal and stable income are assured or in the
sense that only a limited degree of management can be assumed.
Or the same investor may need freedom from management for
part of his fund and be willing to undertake the tasks of selection,
timing, and supervision of the balance of the fund.
Freedom from care through safety can be obtained by making
investments that are subject to little or no shrinkage in dollar
value and income, but such freedom, while important for some
investors, is obtained only at the sacrifice of income. The holder
of an insured deposit in a strong ba,nk has freedom from care
and from one to two per cent interest. The holder of a Series E
Savings bond has freedom from careand 2.9 per cent return if
the bond is held to maturity. To obtain assurance of a steady small
income or to obtain a higher income and still enjoy release from
responsibilities of investment management requires the transfer
of such responsibilities to otherseither investing institutions
which operate a portfolio of investments, or investment counsels.
The importance of freedom from care depends on the size of
the fund, the need of assurance of income and recovery of prin-
cipal, and the degree of attention and skill that the investor is
able to devote to his own investment affairs. All investments in
savings institutions, including deposits, insurance, and annuities,
99
involve delegation of investment authority to others. Investments
in very high-grade securities may be made directly with a mini-
mum of effort and supervision. Investments of all other types re-
quire either delegation of responsibility to others or the ability
on the part of the investor himself to select, appraise, time, and
supervise the funds. It is impossible to generalize on the degree
to which this may be done in a skillful fashion. It is suggested
that in nearly all cases the investment of funds for emergencies,
for home ownership, for essential goals such as education, and,
in many cases, for retirement should be as care-free as possible, in
both the senses in which we use the term.
4. Satisfactory denomination and diversification. To a consid-
erable extent the attainment of the requirements just discussed is
very materially aided by the selection of satisfactory denomina-
tions and by genuine diversification. Diversificationindustrial,
geographical, and by types of investmentsis simply a device for
thinning the risk that is involved in the concentration in all but
the highest-grade investments. It is also a means of increasing the
average return from a fund that might otherwise, for the sake of
safety, be confined to low-yielding securities.
The importance of diversification, and the ability to obtain it,
varies among different investors. The very small fund placed in
government obligations for safety does not obtain but does not
need diversification. In the larger fund, and especially the enor-
mous portfolios of institutions, the opportunity is presented to
achieve a higher return through the inclusion of investments of
less than highest quality, and the risk in such a procedure can be
lessened by spreading the fund over a variety of situations.
Depending on the size of the fund, real estate, real estate mort-
gages, and $500 and $1,000 bond denominations have a disadvan-
tage from the point of view of denomination and diversification.
So do common stocks, where the fund is not large but where such
stocks are appropriate. However, by the use of investing institu-
tions, and the investment company and fire insurance company
insofar as stocks are concerned, a means is provided by which
diversification may be obtained with a small investment. The
investing policies of these institutions is discussed elsewhere.
5. Tax considerations. Tax considerations do not influence the
investment policy of the investor in the low tax brackets. But the
100
higher the investor's income, the more such matters will determine
the character of his investment commitments. Indeed, for very
wealthy investors, it may be the dominating influence. The sub-
ject of taxation of investments is treated in detail elsewhere in
this book (Chapter 18) and in various other chapters where such
material is pertinent. At this point it is only necessary to suggest
that the prospects for continued high personal and corporate taxes
and for substantial estate and inheritance taxes will continue to
have a major influence on many portfolios. Two devices for mini-
mizing taxesthe purchase of tax-exempt state and municipal
bonds and the use of the special capital gain provisionare espe-
cially significant.
6. Protection against inflation. Inflation has followed the five
great wars in which the United States has been involved and is
again a dominating and disconcerting feature of our economy.
The actual decline in the value of the dollar that has taken place
to date and the prospects for a continuation of that decline mean
that to a greater degree than ever before investment policy will
be influenced by attempts to offset rising prices and declining
real income. The means by which such attempts may or may not
be feasible and successful are given full treatment at various
points in this volume. At this point it is necessary to suggest three
problems in connection with the matter of hedging against infla-
tion, each of which will be further developed elsewhere: (1) cash
and high-grade fixed-income obligations provide no protection
at all; (2) the small investor, in making his choice between the
safety of dollars of principal and income and the preservation of
the purchasing power of those dollars, must select the first alterna-
tive, for he cannot afford the risk that the purchase of equities
(with the possible exception of home and business properties)
inevitably involves. One of the tragedies of life is that the investor
who most needs protection against rising prices can least afford
it; (3) common stocks offer an inflation hedge only in varying
degrees, depending on the timing of purchase and sale and the
selection of the particular securities.
The need for a hedge varies among different types of investors;
so does the ability to obtain it. And the degree to which the value
and income of a particular investment are themselves affected by
changing prices is a matter of very serious importance. As has
101
been indicated, the investment plans of some investors, especially
those of institutions with fixed dollar obligations, can ignore infla-
tion; some investors are affected by inflation but can do little or
nothing about it; some types of investors today make the problem
of offsetting the decline in the value of the dollar the dominating
influence in their investment planning. This latter point of view
is based on the assumption of continued inflation, which may or
may not prove to be correct. If the assumption proves to be valid,
it is likely to hold only for the long run.
7. Legality. The final requirement that must be considered, at
least by institutional investors, is the matter of legality. Insti-
tutional investors, especially those in a fiduciary position, must
arrange their programs within the framework of the legal restric-
tions laid down by the state. These restrictions change through
the years, as is indicated elsewhere in the discussion. They apply
with special strictness in some situations, for example in the invest-
ment of savings bank funds, and allow very considerable latitude
in others, as in the case of fire insurance companies and invest-
ment companies. But in all cases, the question of what the insti-
tution would prefer to do is dominated by the legal controls over
what it is permitted to do.
The matter of legality is important to individuals as well as to
institutions. In the first place, any indirect investment through
the medium of a savings or investment institution is ipso facto
affected by the legal requirements bearing on that institution.
Thus, the holder of a life insurance policy of a company whose
state does not permit the company to purchase common stocks
finds the "guaranteed" rate at which his reserve is accumulated
lower (and so the net premium higher) than it might be if such
investments were permitted. In the second place, the investor in
certain securities, notably those issued by states and municipali-
ties, must not only investigate the matters of willingness and
ability to pay but must be satisfied that the security conforms to
the legal requirements within which the borrowing government
may issue its obligations.
The preceding discussion suggests that, to meet a variety of
investment objectives, a number of factors must be considered.
But numerous threats to the meeting of these requirements exist
in the form of risks that the investor should avoid or minimize.
102
Types of investment risk. In determining his goals and objec-
tives, and in considering the general requirements that must be
met if these goals are to be achieved, the investor must be aware
of the risks that he can assume. Whatever he does, some kind of
risk will be present. The central problem of investment is the
weighing of the risks that are involved in meeting objectives and
the determination of the return which the investor can obtain in
the light of these risks. Too often investors ask themselves, "What
return would I like?" and then frame their investment program
in an attempt to obtain such a return. The more proper approach
would be, "What are my goals and objectives, what requirements
must be considered in order to achieve these goals, and what
return can I expect to get or afford to get if these objectives and
requirements are fulfiled?" One of the great temptations of in-
vestment is to incur substantially greater risk, say, through the
purchase of second-grade securities, in order to obtain an in-
creased return that often does not compensate for the increase in
risk involved. For example, at the time of writing the spread be-
tween the yield on a very high-grade bond and a medium-grade
bond is only & to % per cent. It is questionable whether in many
cases the difference is substantial enough to warrant a switch on
the part of those investors to whom safety of capital and assurance
of income are of primary importance. The spread between the
yield on high-grade bonds and common stocks is even more allur-
ing. Why should the investor be content with 2& to 3 per cent
on his savings when he can get 6 to 8 per cent? The answer is
that some investors can afford the risks and benefit by the more
generous returns and possible appreciation from common stock
and some cannot.
1. Selection of highly speculative securities. Investment risks
include those that threaten the principal and income of the fund
and those that threaten its purchasing power. The first one often
encountered by investors is the improper selection of highly
speculative securities to begin with. The argument against such
securities is not that they present hazards. Some investors can
assume great risks in the hope of obtaining a return or an appre-
ciation that will compensate for the risks involved. The chief ob-
jection is that the information provided and the appeals made
may not only be misleading but may play on the avarice of the
103
investor and tempt him beyond the boundaries of sensible risk-
taking. Fortunately the application of the Federal securities legis-
lation of 1933 and 1934 and the stricter enforcement of state
securities legislation have weeded out a number of highly ques-
tionable promotions and offers of securities that could not stand
the light of day. Nevertheless, within the borders of states that do
not require accurate disclosure of facts, the earmarks of a poor
security are still noticeable. The more prevalent practices in this
regard may be grouped as follows:
1. With respect to safety:
(a) The promise of absolute safety.
(b) The irresponsible guarantee.
2. With respect to income and price profits:
(a) The promise of large yields and big profits.
(b) Maintenance of an artificial market and market price.
(c) The promise of an advance in price.
(d) The advice to "get in on the ground floor."
(e) The inference of "inside information."
(f) The use of comparative figures of other enterprises.
3. With respect to purpose:
(a) Spectacular small-scale oil promotions.
(b) The special appeal of mining operations.
(c) The appeal of new and popular industries.
4. With respect to method:
(a) The telephone canvass.
(b) The limited offer to "selected persons."
(c) High-pressure selling.
(d) The use of opinions rather than facts.
(e) The use of prominent names.
Very few of the securities of companies in the development
stage deserve investment consideration. Only those persons who
are able and willing to assume large risk of loss should place their
funds in such enterprises. Admittedly, the rewards obtainable
from an early commitment in a successful undertaking greatly
exceed those that come to investors who wait until earning power
has been clearly demonstrated. The financing of new enterprises
is a worthy and necessary function for people who are in a position
to assume risk, but scarcely the duty of investors who primarily
seek safety.
2. Deterioration of once-sound securities. The problem which
the investor faces in the selection of particular industries involves
104
the avoidance of "over-age" as well as "under-age" companies.
The fact that industries have life cycles through sequential stages
of experimentation, development, saturation, and decline is not
fully appreciated by investors. The biological analogy has been
admirably stated by an outstanding financial economist in the
following quotation: 1
Industries and corporations have their birth and youth. They suffer
from the crudities and struggles incident to rapid growth and economic
adjustment. Capital is difficult to obtain from the outside, but what is
invested in a youthful industry or youthful corporationthrough con-
fidence in the future rather than results of the pastyields large returns.
But such an investment to be more than a mere gamble must be made
with a broad knowledge of the risks involved and a prophetic knowl-
edge of economic values. Such investments are never recommended by
the trustee-lawyer or the country banker. Following the period of youth,
industries and corporations have their stage or epoch of maturity. They
become acknowledged. They compete on a reasonable basis with other
established industries and established corporations for banking credit
and investment funds. Consequently the returns on capital invested in
such industries or such corporations yield a fair rate of interest with a
reasonable, though not excessive compensation for risk. Were it pos-
sible to forecast the length of time, which varies greatly, that an
industry or corporation will remain in this maturity stage, investment
of capital here would be sound and relatively permanent, neither in-
creasing nor decreasing so long as the industry or corporation remained
in this "balanced" condition. And then finally there is the old-age stage.
The industry, and particularly the corporation, lives on, buoyed up for
a considerable time by its past accomplishments. If we are considering
a corporation in the old-age stage, it will show large capital assets,
large bookkeeping surplus, but relatively low current earnings. Never-
theless, its stock will be eagerly bought by the lawyer-trustee because
of its long dividend record. Those who by training and cast of mind
are wont to forecast the future entirely by the weight of accumulated
precedent will regard the old-age industry or corporation, even on the
brink of final dissolution, as thoroughly sound, eminently "conserva-
tive." At the final break of the New Haven bubble, its stock was held
by upwards of 7,000 trustees, a large proportion of them lawyers, ex-
tremely conservative in their investment ideas.
3. Risk of cyclical changes. The cyclical ebb and flow of busi-
ness affects investments in two ways. (1) Corporate earnings and
financial strength rise and fall in varying degrees with general
1 From article by Arthur S. Dewing, in Harvard Business Review, July, 1923.
105
business conditions, some industries and companies being heavily
affected (the "prince-or-pauper" group), some only mildly so,
and a few seeming to escape the cycle altogether; ability to meet
interest and dividend payments is thus directly tied to cyclical
experience. (2) Security prices rise and fall in varying degrees
in anticipation or in reflection of the cyclical changes in earnings,
with equities tending to magnify the fluctuations because of their
relatively inferior position. Irrespective of the quality of any
security, there are times when its purchase would be inadvisable
and other times when it might be most advantageous. The pur-
chase of common stocks at a time of great business prosperity is
dangerous, even though the particular issues may have excellent
records. On the other hand, the purchase of high-grade bonds
during a period of extreme business depression is not altogether
sagacious, despite the natural desire for safety at such a time. The
fact that large investors, such as the life insurance companies, are
continuous buyers of securities, regardless of current conditions,
should not unduly influence the private investor. Life insurance
companies must keep their funds invested at all times and would
quickly have an embarrassing accumulation of capital if they were
to stop purchasing over a prolonged period. Moreover, this policy
enables them automatically to average their costs over good and
bad times.
Ideally, to relate investment policy to the business cycle, the
investor is called upon to make four types of forecasts: (1) of
business conditions as a whole; (2) of security price movements
in general, both of stocks and of bonds; (3) of the movement of
earnings for a particular industry and the probable price action
of securities in that industry; and (4) of the movement of earn-
ings and security prices for a particular company. The degree to
which such forecasts are feasible for the bulk of investors is now
discussed.
The trend of business conditions traces an irregular line, now
advancing, now receding. At times, the advances become so pro-
nounced that they are apparent to everyone in the form of greater
activity and increased earnings. At other times, the recessions
become equally pronounced and are apparent in the form of un-
employment and decreased earnings. As there is a natural tend-
ency for periods of prosperity to be followed by periods of
106
depression, and vice versa, the successive stages are popularly
termed cyclical movements or stages in the business cycle. How-
ever, such fluctuations in business activity rarely follow a curve
of regular ascent and descent. The absence of uniformity in the
extent and duration of business movements makes economic fore-
casting a most difficult problem.
The suggestion is here made that the great bulk of investors
should not attempt the difficult if not impossible task of forecast-
ing the general business cycle. About the most they can hope to
accomplish is to recognize the current phase, whether it be de-
pression, recovery, boom, or panic, and govern themselves accord-
ingly.2 The avowed aim of the Federal Government to maintain
full employment and to take many courses of action to prevent
excesses either of inflationary booms or deflationary recessions
may appear to make the obligation to forecast much less necessary
than was once the case. Actually, the potential for such excesses
still remains. The war economy in which the United States has
lived for some years and will continue to live will go far toward
preventing the early recurrence of a drastic depression such as
occurred in 1929-1933. A post-armament "recession," however,
remains a strong possibility.
If security prices followed the same cyclical pattern that is
apparent for business as a whole, the investor's problem would
be greatly simplified. He would determine to his own satisfaction
the phase in which business in general appears to be operating,
and act courageously and somewhat contrary to his natural in-
clinations. He would buy securities in periods of depression and
2 An interesting device for recognizing the current phase of the cycle and of
predicting the next phase is presented in a recent study by the National Bureau of
Economic Research. An indicator is suggested composed of 15 selected economic
series, each of which has been adjusted for the seasonal factor and has been
smoothed and weighted with the number of months it has been going either up or
down. The result gives the number of months that the average of the group has
been moving up or down. The study of this indicator as it would have applied
over a 30-year period reveals that whenever the indicator has shown a three-months
decline, a recession has always developed, no matter how good business may have
looked at the time. Thus, when the Federal Reserve Board index of industrial
production stood at 192 in December, 1948, the trend indicator showed an
average drop of 3)j months in the series. By July, 1949, the business index had
declined to 161. G. H. Moore, Statistical Indicators of Cyclical Revivals and Reces-
sions. (New York: National Bureau of Economic Research, Inc., Occasional Paper
No. 31, 1950.) It will be interesting to watch the testing of this approach in the
1950's.
107
sell them when he felt that the boom period was nearly at an end.
Such a general policy would be based on the assumption that the
investor has the capacity of intelligently interpreting the trend of
business activity; it further assumes that the investor must have
the patience to await the opportune time to buy, as well as to sell.
Such qualities could not be expected of many investors.
Regardless of his ability or willingness to interpret business
trends and to act somewhat unnaturally from a psychological
aspect, such an approach would be faulty for three reasons. The
first is that stock prices and earnings in general do not always
move in the same direction, as a study of the period 1938-1950
reveals. The second is that different industries have different
cycles. The amplitude of the variations in their profits (and of the
prices of their stocks) is considerable. In fact, some industries are
depressed in times of general prosperity (for example, bituminous
coal and textiles in the late 1920's). Others prosper in times of
depression, either because they benefit from lower costs of opera-
tion and a relatively fixed demand for their products (as in gold
mining) or because their secular growth more than offsets a
temporary cyclical influence.
The third and more important reason is that the movements of
common stocks and low-grade bonds and of preferred stocks and
high-grade obligations do not coincide cyclically. In a period
when business is recovering from an inactive stage, prices of both
bonds and stocks advance, the increased earning power of busi-
ness enhancing the safety position of bonds and improving the
dividend prospects for stocks. In a period of business activity,
bond prices decline somewhat, owing in part to the effect of
higher interest rates and in part to the increased popularity of
stocks; during this same period, stock prices continue to advance
practically to the peak of the boom, reflecting continued increases
in corporate earnings. In a period when business is declining,
prices of stocks fall more rapidly than prices of bonds, owing
chiefly to the realization that earning power was too liberally
estimated in prosperous times. In a period of business depression,
prices of bonds strengthen, because of the safety factor, whereas
prices of stocks reach low levels. It might be observed that
bond prices tend to move ahead of stock prices, rather than con-
versely. In periods of prosperity, stock prices are high and bond
108
prices are low;3 in periods of depression, bond prices are strong
and stock prices weak.
It is suggested that insofar as high-grade bonds are concerned,
as long as they remain high-grade, the investor can safely ignore
those cyclical price changes that arise (as we shall see later)
mainly from changes in interest rates and not from changes in
the issuers' earnings or financial condition. It is further suggested
that, since the investor's main interest lies in acquiring and hold-
ing suitable securities at suitable prices (in contrast to the specu-
lator's main interest in profiting from price fluctuations), he ignore
price declines in stocks unless they are very substantial indeed or
reflect a deterioration in inherent quality apart from general
market changes. Insofar as price rises are concerned, he should
sell stocks if he is convinced that they are overvalued in terms of
long-run prospects, and not merely because he believes the peak
of a stock market boom is approaching. The reason for such a posi-
tion is that, if the investor attempts the hazardous task of selection
and sale of stocks (and low-grade bonds) on the basis of his judg-
ment concerning the phase of the security-price cycle, not only
is he likely to be wrong a good deal of the time, but he is in
danger of stepping over the line from the point of view of an
investor to that of a speculator. If he concentrates on values rather
than on mere price movements as such, he is likely to keep his
money more fully employed and produce a better long-run result.
That is to say, if he purchases a stock because it is undervalued in
terms of its own merits and not because the general market is low,
or sells it because it is overvalued and not merely because he feels
the general market is high, in the long run he is likely to benefit
more from price fluctuations than if he attempted to set himself
up as smarter than the trading public, insofar as the forecast of
the market as a whole is concerned. He does not ignore market
price fluctuationshe uses them as a basis of judgment concerning
the value of his securities and not as the basis of a speculative
game.
As was indicated previously, industries, and the prices of their
3 The movement of high-grade bond prices in the prosperity period of the late
1940's and early 1950's does not conform to this pattern, largely because of the
great institutional demand for bonds and the special support of government bond
prices (and hence of prices of all high-grade bonds).
109
stocks, do not act alike insofar as cyclical variations are concerned.
One of the disadvantages of using the earnings or price record of
any average or group of securities, especially of stocks, as indica-
tive of the general trend is that within the group certain industries
go counter to the group. Thus, in the mild downturn in 1949, the
profits of 1,006 manufacturing corporations fell 10 per cent as
compared with 1948.4 To choose a few examples, earnings in the
auto and truck group, however, rose 31 per cent, glass products
28 per cent, and agricultural implements 22 per cent. But steel
earnings declined 1 per cent, petroleum products 26 per cent,
household appliances 47 per cent, and cotton goods 60 per cent.
Although the prospects for a particular industry are easier to
determine than those for the economy as a whole, industrial se-
lection can never be made on a haphazard basis.
So-called "growth" industries offer a special appeal over the
long run. But even these have to be selected carefully, and much
patience may be required over a considerable period, as the dis-
appointing early results in the air transport group bear witness.
Companies with aggressive management, that follow a program
of research to develop new products and markets and enjoy
strong finances and an increasing return on invested capital, fit
best into the growth pattern. To qualify as sound-growth situa-
tions, the rate of earnings should reach a new high with each
cyclical peak and should grow at a rate faster than that of the
cost of living, if the real advantages of growth are to be enjoyed
by the stockholders. One difficulty with "growth stocks" is that
the investor may be required to pay too high a price for the
growth factor.
The prospects for an individual company, like those for an
industry, can best be determined by analytical methods. The
investor can take advantage of the cyclical swings in the general
market by purchasing securities, notably equities, when they
appear undervalued, except when the whole general market is in
an extreme range and even the most promising situations are
vulnerable to a general collapse in market price. And he can use
the market appraisal for determining the points at which to sell
securities when they are overvalued market-wise. And it is im-
* National City Bank of New York, Monthly Letter, March, 1950.
110
portant to realize that companies in general or even all companies
in a given industry do not act alike with respect to prospects and
price. In 1949, as indicated previously, the earnings of the motors
group went against the general trend in industrial earnings by
showing a substantial increase. Those of General Motors Corpora-
tion rose 49 per cent over 1948 and contributed very substantially
to the showing of the group. But during the same year the earn-
ings of White Motor Company declined 72 per cent. As for stocks
in general, it is interesting to note that in the generally good stock
market year of 1949, over 300 issues20 per cent of those listed
on the New York Stock Exchangewere lower in December than
in January. In April, 1950, the Dow-Jones average of 30 industrial
stocks reached 212its 1946 high. But 15 of the 30 stocks were
10 per cent or more below their 1946 highs! In 1950, this average
rose 17.6 per cent, but 218 of the 1,039 common stocks listed on
the New York Stock Exchange declined.
4. Risk of changing money rates. The prices of securities rise
and fall owing to changes in interest rates as well as because of
changes in quality as measured by earnings and assets protection.
The prices of the most riskless of marketable long-term issues,
namely, Treasury bonds, are affected solely by the former factor,
aside from the influence of Federal support. They have sold to
yield as high as 6.6 per cent (1920) and as low as 2.12 per cent
(1946). Yields on other bonds reflect changing interest rates and
changing quality.
Interest rates on loans vary according to the condition of the
money market, the position of the borrower, and the duration of
the loan. Interest rates on commercial loans for less than one year
tend to vary with the business cycle, whereas interest rates on
investment loans for upward of 20 years are affected more by
long-term influences. Although the short-term commercial and
the long-term investment interest rates are dependent upon the
supply of loanable funds available in the market, and thus tend
to move together, the investment rate is relatively more stable
than the commercial rate which fluctuates over a wider area with
changes in the business cycle. A notable example of this tendency
was illustrated in 1929, when the interest rate on call loansthe
shortest of all commercial loanswas over 10 per cent and the
comparable rate on investment loans was around 4 per cent. A
111
decade later in 1939, the interest rate on call loans was 1 per cent
and the rate on long-term high-grade corporate bonds was around
3 per cent. In 1950 the comparable rates were 1.6 per cent and
2.65 per cent.
Interest rates on long-term investments follow secular trends
which are separate from cyclical influences. The first 50 years of
the present century provide an illustration. The prevailing rate
of return on high-grade long-term bonds in 1900 was around 3 per
cent with no indication of higher rates for years ahead.3 A decade
later, the comparable yield had risen to 3.75 per cent. In 1920 it
had advanced to 5.25 per cent, which marked the culmination
of the long advance. By 1930, the average rate had fallen to 4.30
per cent and in 1940 it had declined further to 2.60 per cent, or
below the rate which had prevailed in 1900. Rates fluctuated
mildly in the 1940s, and in 1950 they were only slightly different
from those of 1940. They rose somewhat in early 1951 as a result
of changed Federal Reserve policy with respect to the support
of government bond prices. The yield on high-grade corporates
was 3.0 per cent at the close of the year.
Experience has demonstrated the futility of attempting to pre-
dict the turning points in long-term interest rates. If economic
history is to prove a reliable criterion, however, a reasonably sound
statement appears to be that such interest rates should not long
continue above 5 per cent or under 3 per cent. However, in the
early 1950's the pressure for investments on the part of institu-
tional investors, together with the Treasury insistence on low
rates to finance the growing Federal debt, offers the prospect of
continued low bond yields and continued high prices on high-
grade bonds. While the prices of long-term government bonds
were "unpegged" in March, 1951, Federal support to the bond
market would undoubtedly be reinstated if a marked rise in inter-
est rates were to take place.
Investors who purchase bonds near the end of a long decline in
interest rates face an added hazard in prospective depreciation
in market value of the bonds if interest rates should, for some
5 A large life insurance company in New York asked 50 of the leading financiers
of the country in 1900 if higher interest rates were likely to develop over the next
20 years. Every reply was to the effect that rates would remain the same or go
lower. Not one reply predicted higher rates!
112
reason, rise. At times when interest rates are abnormally low, the
purchase of relatively short-term bonds is more advisable than
the purchase of long-term issues. The closer the maturity date of
a bond is, the greater is its price stability. A 3& per cent bond due
in ten years is worth 108% in a 22i per cent market and is worth 100
in a 3/s per cent market; a rise in interest rates from 2& to
3)j per cent would cause a decline of 8 per cent in market value.
A 3& per cent bond, however, due in twenty years is worth 115%
in a 2& per cent market and is worth 100 in a 3?2 per cent market;
a rise in interest rates from 2)& to 3)2 per cent would cause a de-
cline of J 3 per cent in market value. A similar 3& per'cent bond
due in forty years is worth 125^ in a 2& per cent market and is
worth 100 in a 3& per cent market; a rise in interest rates from 2&
to 3)2 per cent would cause a decline of 20 per cent in market
value.
The natural desire on the part of investors to buy short-term
bonds in periods of low interest rates so increases the demand for
these issues as to result in higher market prices. In 1930, when
interest rates were fairly close to normal, the rates of return
obtainable from short-, medium-, and long-term bonds were about
the same. In 1950, however, with interest rates abnormally low, a
wide variation existed, as illustrated in prevailing yields on high-
grade corporate bonds of & to 1 per cent on two-year bonds, 11*
per cent on five-year bonds, 1% per cent on ten-year bonds, 2&
per cent on twenty-year bonds, and 2% per cent on thirty-year
bonds. In 1920, when interest rates were abnormally high, the
comparable rates were in striking contrast, as shown in prevailing
yields of 9& per cent on two-year bonds, 7% per cent on five-year
bonds, 6 per cent on ten-year bonds, 5& per cent on twenty-year
bonds, and per cent on thirty-year bonds.
The desire on the part of investors to obtain a favorable rate of
return from their investments frequently results in the assumption
of risk beyond a reasonable limit. The highest-grade issues afford
the lowest yields because they are exceptionally well secured and
have the greatest price stability. The lower-grade issues afford
higher yields because they are less secure and are more subject to
fluctuations in market value. In the drastic decline of the bond
market between 1930 and 1932, a representative group of bonds
declined about 30 per cent in total market value. The first-grade
113
bonds declined only 10 per cent; the second-grade bonds declined
about 25 per cent; the third-grade bonds declined about 40 per
cent; and the lowest-grade bonds declined about 50 per cent. In
view of the fact that the purchase of the lower-grade bonds in
1930 would have afforded rates of return only about 1 per cent
higher than the higher-grade issues, the additional compensation
was not commensurate with the greater hazard involved. The
same was true in 1950, when the yield on Moody's Aaa corporate
bonds was 2.6 per cent and on Baa bonds 3.25 per cent.
There is little question that second-grade bonds should be
bought only by persons who can afford to assume a high degree
of risk. It is an axiom of the investment business that the higher-
grade the securities the smaller will be the potential market de-
preciation. While it is true that high-grade bonds sometimes prove
to be poor investments, seldom indeed do low-grade bonds prove
to be good investments. On the whole, securities tend to lose
quality over periods of time, thus emphasizing the great desira-
bility of buying the better-grade issues.
Changes in money rates also affect the prices of preferred and
common stocks. The very highest-grade preferred stocks act more
like bonds, with price reflecting mainly changes in interest rates.
Lower-grade preferreds act more like common stocks. The rate at
which the market capitalizes the earnings on a common stock
may be said to include the basic interest rate plus an additional
increment that reflects the risk in the situation. Stated in an over-
simplified fashion, the value of a share of common stock reflects
principally the expected future earnings capitalized at a rate that
is commensurate with the risks involved, adjusted for the actual
dividend prospects. The value therefore changes when either or
both of the two components (earnings and capitalization rate)
change, and the most drastic change in value, of course, occurs
when the two components change in opposite directionsthat is,
when expected earnings decline (or increase) and the rate of
capitalization increases (or declines). A simple hypothetical ex-
ample will serve to illustrate this point. If the anticipated earnings
on a share of common stock are $5 and the rate of capitalization
demanded by the market is 10 per cent, the value of the stock is
$50. If the earnings remain the same, but the rate is reduced to 5
per cent, the value is $100. The value of a share of stock may thus
114
change through the influence of the going rate for the risk in the
particular situation even though the outlook for earnings remains
the same. But if the earnings are $10 and the rate is 5 per cent,
the value is $200.
It is customary in financial circles to express the relationship
between earnings and price in terms of a multiple of earnings, or
the reciprocal of the rate of capitalization. Thus, where the market
capitalizes $5 of earnings at 10 per cent to produce a value of $50,
the stock is said to sell at 10 times earnings; capitalization of $5
of earnings at 20 per cent means that the stock sells for 5 times
earnings. The actual record of the 30 stocks making up the Dow-
Jones Industrial average shows how market price may be influ-
enced principally by the rate of capitalization or its reciprocal,
the multiple of earnings. In October, 1945, the average stood at
185, a figure that was 18.1 times expected earnings for 1945. In
August, 1948, the average stood at 184, an almost identical figure;
but this was only 8.8 times expected 1948 earnings. Between the
two dates, the rate or multiple that satisfied traders in these
common stocks as a group had changed so materially that even
the very substantially higher earnings on the group of stocks
produced only the same average value.
The preceding explanation of the forces affecting the prices of
common stocks is, of course, greatly oversimplified in that it gives
no attention to the influence of stability of earnings, dividend
record, or asset valuesfactors that have considerable influence
on stock prices. But it does serve to indicate that the investor in
common stocks must be prepared to see the market values of his
securities decline even though earnings remain stable or even
increase; it also suggests the possibility of substantial appreciation
in price even in the face of declining earnings.
5. Risk of changes in purchasing power. Even though the dol-
lars of principal and income may remain the same, their real value
in terms of purchasing power rises and falls with changes in the
price level and the cost of living. This fact is becoming increas-
ingly important as the prospects for rising prices through war and
post-War inflation are confirmed. The dollar lost one-half of its
purchasing power as a result of World War I and 40 per cent of
it as a result of World War II. Protection against the purchasing-
power risk, or inflation hedging, thus becomes an increasingly
115
important consideration for those investors who can afford to
assume the risks that such protection inevitably involves. It is the
basis for much of the current discussion concerning the position
of an investment fund that should be placed in "aggressive" securi-
ties or other investments of the equity type.
The loss of value of both principal and income that arises from
rising prices and cost of living is easily illustrated by referring to
the changes that took place in the decade 1940-1950. The Bureau
of Labor Statistics, Department of Labor, Consumer Price Index
for moderate-income families stood at 100.7 at the end of 1940
(1935-1939 average = 100). At the end of 1950 the index was
178.8. Thus, the buying power of $1.00 cash or principal in securi-
ties was reduced to 56 cents in the ten-year period. An investor
who had bought a $100 Savings bond for $75 in 1940 was repaid
$100 in cash in 1950, but only $56 in purchasing power. Similarly,
any fixed income had been reduced in effective value by the same
amount over this period.
In the light of the decline in the purchasing power of each
dollar of the investor's income and principal, it is not surprising
that a growing number of investors are seeking a means of pro-
tection against inflation, possibly at the expense of sound invest-
ment principles and of safety. Only those institutional investors
whose obligations are in terms of dollars are oblivious to the
shrinkage in the buying value of their portfolios, and even these
are confronted with rising costs of operation that indirectly influ-
ence their need for higher investment income. It is, of course, the
individual investor, whose holdings consist primarily of fixed-
income securities, or who is otherwise in the position of a creditor,
say, as the recipient of an annuity or pension, who is hit the
hardest by inflation. And unfortunately, the smaller the fund and
the more important each dollar of it, the greater is the impact of
reduced purchasing power and the greater is the temptation to
sacrifice the certainty of dollars for the possibility of greater buy-
ing value. Conversion of a substantial portion of the fund to
common stocks and to real estate, in the hope of obtaining (1) a
greater dollar income and (2) an appreciation of principal be-
comes very tempting when the prospects for continued inflation
are strong.
Investments in real estate and in common stocks offer the most
116
possibilities of an inflation hedge. But the former represents a
highly specialized type of commitment and one that requires
considerable management, knowledge of land values, and knowl-
edge of community development. It also has the disadvantage of
inadequate diversification.6 Common stocks, on the other hand,
are easily bought and sold, and in large or small amounts. Much
has been written and said about the practicability of looking to
common stocks for protection against rising prices. And this pro-
tection is, in fact, afforded over long periods of time, but subject
to decided limitations. The 11-year period 1940-1950 again pro-
vides an illustration of the fact that over a considerable period
commodity prices and the cost of living, on the one hand, and
common stock prices, on the other, do move in the same general
direction. The following schedule shows: (1) the Bureau of Labor
Statistics Consumers' Price Index (1935-1939 average = 100), (2)
the Bureau of Labor Statistics Index of Wholesale Prices (1926 =
100), and (3) the price, earnings, and dividends of Moody's
Index of 125 Industrial Stocks. In each case, the average for the
year is shown.
PRICE INDEXES AND COMMON STOCKS
BLS
BLS
Wholesale
Moody's 125 Industrials
Year
Consumers'
Commodity
Price Index
Price Index
Price
Earnings
Dividends
1940
100.2
78.6
$31.76
$2.59
$1.67
1941
105.2
87.3
28.70
2.95
1.81
1942
116.5
98.8
25.70
2.36
1.64
1943
123.6
103.1
34.18
2.40
1.55
1944
125.5
104.0
36.57
2.73
1.67
1945
128.4
105.8
43.94
2.72
1.75
117
clined; the same was true in 1946-1947. And the relatively sharp
rise in common stocks, 1944-1945, took place during a period of
relatively stable prices. Over the short run, stocks seem to prefer
stability to uncertainty in one direction or another. When com-
modity prices started to climb in 1946, the stock market collapsed.
The baby bull market of 1948 came to a halt when commodity
prices rose to record levels. And the big rise in stocks from the
middle of 1949 to the middle of 1950 was accompanied by declin-
ing commodity prices. Part of the explanation lies in the fact that
dividends do not rise as fast as prices, and that high prices and
high earnings in a period of inflation are accompanied by high
taxes and the prospects of still higher ones.
The limitations of common stocks as an inflation hedge may be
summarized as follows:
1. The hedge works only over a considerable period of time.
2. The stocks must be purchased at depressed levels within
this period.
3. All stocks are not equally good for inflation protection. Var-
ious industries, and hence their common stocks, act differently
with respect to earnings. Sub-groups of stocks go in different
directions even during a period of general rise. The problem of
selection still persists.
4. Although corporate earnings may rise with inflation, divi-
dends do not rise in the same proportion. Corporations pay out a
smaller percentage of earnings in a period of boom and uncer-
tainty. The protection to income that is sought by an inflation
hedge is therefore substantially reduced.
5. The appreciation in corporate earnings that is noted in a long
inflationary period is not all reflected in stock prices, because the
market then applies a lower multiple to earnings than during
periods of stability. In 1940 the 125 stocks making up Moody's
industrial series sold at between 12 and 13 times earnings. In 1950
the multiple was between 6 and 7.7
7 For an interesting study of the comparative changes in cost of living and stock
prices in 20 countries, 1937-1948, see G. W. Coleman, "Inflation and Common
Stock Prices," Current Economic Comment (University of Illinois), May, 1950,
pp. 16-17. The author concludes, "Perhaps the only conclusion that can be reached
from the data presented in this article is that, at least in recent inflations, there is
no consistent relationship between increases in the cost of living and advances in
the price indexes of industrial shares."
CHAPTER 8
(CONTINUED)
Scope. This chapter continues the discussion of investment
principles begun in Chapter 7. The order of discussion is: mini-
mizing risk by (1) appropriate selection, (2) intelligent valuation,
(3) proper timing, (4) adequate diversification, (5) continuous
management and supervision. The chapter concludes with (6)
management of investments by others and (7) safeguarding of
securities.
Methods of minimizing risk. While it is difficult to fulfil all of
the requirements called for in a given situation, and impossible
to eliminate all of the risks that were outlined in the previous
chapter, certain investment policies will at least go far toward
minimizing those risks.
1. Intelligent and dispassionate selection of media. Much of the
latter part of this book will be devoted to the analytical methods
that are useful for the intelligent selection of industries and indi-
vidual companies if the purchase of securities is to comprise an
element in the investment program. But lying behind the choice
of individual industries and securities is the more fundamental
problem of selection of the appropriate general investment media
that will best serve the needs of the particular investment situa-
tion and provide the requirements that the situation calls for.
Possibly neither corporate stocks nor bonds are necessary or de-
sirable to achieve a certain goal. If so, the investor avoids the
whole problem of analysis of corporate securities. As we have seen
in the previous chapter, before individual selections are made, the
order of investment planning runs: (1) determination of goals and
objectives; (2) recognition of the investment requirements that
must be met if these goals are to be achieved; (3) appraisal of the
various types of risk; (4) choice of the general types of media
118
119
that are most feasible in the investment situation. In many cases,
corporate stocks at least will not be reached at all in this order of
thinking.
Intelligent selection will help to avoid the selection of highly
speculative securities to begin with, if such securities are not
appropriate in the investor's portfolio. It will aid in the recognition
of the deterioration of investments that were once sound but have
since lost ground. It can help to offset the risk of cyclical changes
in individual securities whether caused by factors affecting those
securities alone or by general market factors. It is valuable in
minimizing the money-rate risk in two respects: (1) in aiding the
investor to determine whether the premium over the interest rate
that is offered by the yield on the investment (either bonds or
stocks) is adequate, and (2) in suggesting a program of staggered
maturities in a bond portfolio that will go far to offset the fluctua-
tions in interest rates and will aid in profiting from favorable
trends as they develop. And we have seen that proper selection
is vital if any advantage is to be had from investment in equities
as a means of inflation hedging.
2. Intelligent valuation. In those cases in which securities are
to form a part of the investment program, the price at which a
security is to be bought (or sold) is as important a decision as the
selection of the security itself. As suggested earlier, the investor
may not be equipped to recognize any but the most violent cycli-
cal swings in the market as a whole; but this does not eliminate
the necessity of recognizing when a particular instrument is over-
or under-priced on its own merits. One of the disadvantages of
concentrating purchases of stocks in the "blue-chip" group is that
these stocks often sell at a premium resulting from their popu-
larity; furthermore, the unwary investor may fail to recognize
that they have lost their blue-chip quality until after that condi-
tion has become evident. Possibly the most difficult task in the
field of investments is that of determining what a security is really
worth. Aids to this task are suggested in the latter half of this
volume. In passing it should be noted, however, that valuation of
securities, especially of equities, can be made only within a con-
siderable range. Since such securities are ordinarily purchased
and sold on the basis of going-concern value, no man can tell pre-
cisely what they are worth. The common stock of General Electric
120 INVESTMENT PRINCIPLES
Company may be undervalued at 40 and overvalued at 50. To
decide that it is worth precisely 45, and not 44 or 46, however,
leaves no room for all of the uncertainties of the present and the
future which confront any stock.
It is obvious that intelligent valuation of investments will aid in
minimizing all of the risks that have been previously discussed.
All of those risks are magnified if the investment is over-priced
when purchased or under-priced when sold.
3. Proper timing. Equally important, and equally difficult, is
the problem of the timing of purchase and sale. It has been sug-
gested previously that this problem involves four types of fore-
casts that for the great majority of investors are either difficult or
impossible. It was also suggested, however, that advantage could
be taken of the fluctuations in security prices in the selection of
securities on their own merits. To do so may require patience and
the ability to ignore the crowd psychology of the moment.
Three types of devices have been developed to aid the investor
either to determine the direction of the stock market or to elimi-
nate the necessity of so doing. The first type includes all of the
many technical devices that look at the action of the market itself
as the indicator of its direction and of the direction of business.
Of these, the most well known is the Dow theory.
It has long been observed that the market prices of common
stocks tend to move upward or downward over extended periods
of timea movement which is obscured by short-term fluctuations.
An early observer of these price movements (Charles H. Dow,
one of the founders of the Dow-Jones services) formulated a
method of interpretation, known as "the Dow theory of price
movements," which has gained wide recognition among students
of market conditions.
Stated in its simplest form, the Dow theory is a mechanism
which is designed to indicate the major trend of the market with-
out forecasting the extent of the movement in time or degree. A
comparison of the successive high and low points reached in the
normal fluctuations of the stock market enables an observer who
notices that the successive high and low points are advancing or
declining to determine the trend of the market. If the price aver-
age should rise from a low point of 120 to a high point of 130,
then fall to 125 and advance to 135, an upward trend was indi-
121
cated when the decline stopped at 125 and was confirmed when
the new advance went above 130. If the upward trend continues
until the price average reaches 150, a subsequent change in the
direction of the market trend would not be indicated until a re-
cession from that level was followed by a recovery to less than
150 and a subsequent recession to a lower point than on the pre-
ceding decline. In an advancing market, a change in the direction
of the trend is indicated when an advance fails to carry higher
than the preceding advance and when a decline goes lower than
the preceding decline. In a declining market, a change in the
direction of the trend is indicated when an advance goes higher
than the preceding advance and when a decline does not go so
low as did the preceding decline.
The Dow theory is based upon the use of both industrial and
railroad stock prices and is valid only when the movements of
both averages are confirmatory. When all of the fundamental
forces in the market are bullish, both the rail and the industrial
averages will advance, and new high points will be made by both
averages, each confirming the other. If either average consistently
refuses to confirm the other, a major movement is probably near
its end.
The Dow theory does not pretend to forecast the duration and
degree of price movements, and often it does not indicate a
change in the direction of the trend until long after the change
has taken place. Thus, in 1937, the Dow-Jones industrial stock
price average reached a high point of 194 in March and had de-
clined to 165 before the downward trend was confirmed under
the Dow theory five months later. Subsequently a low point of
99 was reached in March, 1939, but the Dow theory did not con-
firm an upward reversal until the average was above 140 some
six months later. But use of the theory does offer warnings that
may prevent complete disaster to those who can understand and
apply it.1
A second method of dealing with the timing factorin fact, of
avoiding itis known as dollar averaging. This method is useful
to investors who are accumulating capital and who wish to avoid
1 For a study of the indicated results from the Dow theory applied to the Dow-
Jones Industrial average, 1897-1948, see Benjamin Graham, The Intelligent In-
vestor (New York: Harper and Bros., 1949), pp. 30-32.
122
always buying common stocks when they are too high and to
benefit from the expected variations in market price. Stated in its
simplest terms, this involves regular purchase of securities in
equal dollar amounts, regardless of their unit price. As the price
of the security or securities bought declines and rises, a greater
or smaller number of shares can be bought with the same amount
of money. Over a long period of time, as long as the market price
rises and falls, the average cost of all shares purchased will be
lower than the average price at which the shares are bought.
These elements may be illustrated by a simple example. Suppose
that $1,000 is invested in the shares of a company at regular in-
tervals, beginning at $50 per share, with a subsequent decline to
20 and recovery to 50:
Shares
Purchased
Each
Price
Interval
1st purchase
$50
20
2nd purchase
40
25
3rd purchase
30
33.3
4th purchase
20
50
5th purchase
30
33.3
6th purchase
40
25
7th purchase
50
20
Total
Value
Total
Total
of
Shares
Amount
Invest-
Purchased
Invested
ment
20
$1,000
$ 1,000
45
2,000
1,800
78.3
3,000
2,350
128.3
4,000
2,567
161.6
5,000
4,850
186.6
6,000
7,467
123
the stocks to be purchased with care; some will move with and
some against the market as a whole. It is recommended that the
program consist of the regular purchase of shares of well-managed
investment companies. Some of these offer plans whereby divi-
dends are automatically reinvested in new shares.2 The effect of
the compounding of such dividends, coupled with the regular
investment of new principal, is to produce a very substantial ac-
cumulation over a period of years, provided the period is long
enough and provided the investor has the fortitude and emotional
poise to continue buying when the market is declining and to wait
for any sale until the market has recovered from a present decline.
A third method of defeating the timing problem is the use of
a formula plan by those investors who have already accumulated
a substantial fund and whose problem is to preserve and increase
their capital over the years and at the same time avoid the use of
judgment concerning the course of the market. The use of a for-
mula plan is designed to substitute an automatic device for pos-
sibly emotional and erroneous decisions concerning the best
buying and selling points. It offers a compromise by which the
investor can take some advantage of the swings in the market.
Formula plans differ considerably, but they all have in common
the use of two fundsthe "aggressive fund," consisting of common
stocks, and the "defensive" fund, consisting of high-grade bonds
or possibly cash. Under the constant-ratio type of plan, the in-
vestor determines in advance the proportions of aggressive and
defensive securities that he wishes to maintainsay, 50-50. When
the market moves up and down sufficiently to alter this ratio by a
predetermined amount, he switches funds from one to the other
of the type of securities to restore the original ratio. Thus, the plan
used by Yale University to govern its endowment fund starts with
a "normal" ratio of 30 per cent in common stocks and 70 per cent
in bonds and preferreds. In a rising market for common stocks,
the common stock portion is permitted to rise until it reaches 40
per cent of the value of the fund; it is then cut back to 35 per cent.
In a falling market, after the common stock portion reaches 20
per cent, stocks are bought to maintain this portion at 25 per cent.
Under the variable-ratio type of plan, the proportion of stocks
2 See p. 577.
124
is reduced in a rising market and increased in a declining market,
the decisions being based on predetermined levels in a selected
market index. When the stock market, as measured by an average,
reaches a predetermined point on the up-side, stocks are gradu-
ally sold and all or part of the proceeds are placed in cash or
bonds. When the stock market reaches a certain point on the
downward cycle, bonds are sold or cash is used to purchase stocks
on a gradual basis. In a sense, such a procedure is a compromise
application of the "buy-low-sell-high" principle. To produce satis-
factory results, the following conditions must be met: (1) a
satisfactory formula must be devised; (2) stock prices must have^
moved up and down sufficiently to bring the plan into action;
(3) the common stocks to be purchased must be carefully selected
(shares in well-managed investment trusts are recommended);
(4) the price action of the particular securities selected must not
deviate from that of the market as a whole; (5) the market must
not remain- on a permanently high or low level; (6) the investor
must exercise great patience and fortitude by selling when stocks
are rising, buying when they are falling, waiting out the greater
peaks and valleys that may appear after his action has been taken.
Numerous institutions have adopted formula plans, and certain
investment companies make such plans available to the holders
of their shares.3 If the conditions cited previously are not met, no
automatic device will produce satisfactory results except by acci-
dent.
4. Adequate diversification. Tp the protection afforded by the
careful selection of commitments, the intelligent investor will add
the safeguard of diversification. Through a distribution plan over
a number of issues, he does not lessen the risk attendant upon any
one security, but he does limit the loss that would be encountered
if a substantial part of his fund were concentrated in an issue
which depreciated in value. The application of a principle in
mathematics, loosely termed the law of averages, based upon the
improbability of the concurrence of unrelated unfavorable factors,
underlies this policy of diversification.4
3 See p. 578.
4 In interesting contrast to his well-known admonition to "put all your eggs in
one basket and watch that basket," as suggested by Andrew Carnegie in The
Empire of Business, his estate contained the securities of more than 50 different
companies.
125
Diversification is more than a theory. It is accepted as sound
practice by all large investors and has been officially recognized
by legislative bodies and courts. The New York State law defi-
nitely limits the proportion of funds that savings banks may invest
in real estate mortgages (65 per cent, not including FHA-insured
mortgages), in railroad bonds as a group (25 per cent) and as
single companies (10 per cent), in electric and gas bonds as a
group (10 per cent) and as single companies (2 per cent), in
telephone bonds as a group (10 per cent) and as single companies
(2 per cent), in housing projects (5 per cent), and in moderniza-
tion loans (1 per cent).5 The courts have held that trustees should
diversify trust funds, and they have, in at least one case, surcharged
a trustee for a substantial loss sustained from an unduly large
investment in a single issue.6 Moreover, as will be shown, com-
mercial banks, insurance companies, investment companies, and
other large investors almost universally practice diversification
methods.
The simplest manner in which diversification is accomplished
is through limitation upon the proportion of the total fund that
may be invested in any distinct category. The more popular appli-
cations of such restrictions, from the aspect of safety, are limita-
tions of the amounts which may be invested in: (1) any one se-
curity or company, (2) any one kind of enterprise, (3) any one
grade of securities with respect to (a) yield and (b) market-
ability, and (4) any one geographical district. From the view-
point of convenience, restrictions apply less rigidly to: (1) in-
come payment dates, (2) maturity dates, and (3) maximum and
minimum commitment amounts.
The proportion of the total fund that may be invested in any
single issue should be limited to a reasonable degree. The quality
of the issue has direct influence in this respect, since the percent-
age may be higher in the case of exceptionally safe investments,
such as United States Treasury bonds, Savings Bonds, and others
of very high caliber.
The proportion to be invested in any one kind of enterprise
should also be limited. As before, the investment position of each
group should be considered so that higher ratios may be estab-
5 See pp. 145-148 for greater detail.
183 Massachusetts 499 (1903).
126
lished for the more promising fields. The various groups into which
securities may be classified for this purpose are as follows:
I. United States Government obligations, including guaran-
teed issues.
II. United States Government instrumentalities.
III. Domestic state and municipal bonds.
IV. Domestic steam railroad securities.
V. Domestic public utility securities.
VI. Domestic industrial securities.
VII. Domestic bank and insurance stocks.
VIII. Investment company securities.
IX. Real estate securities.
X. Foreign securities.
It is not suggested that some part of the fund should be invested
in each of these ten groups. The principle of diversification does
not require such extreme conformance. For example, under pres-
ent conditions most plans would rule out the last group men-
tioned. It is suggested, however, that an investment fund should
not be concentrated in any one of these groups to the exclusion
of the others. The acquisition of many separate issues in a single
group is diversification of a nature much more limited than that
considered in the present discussion. The investor, for example,
who believes that he is practicing diversification through the
simple expedient of confining his purchases to the securities of
public utility companies located in different parts of the country
is operating under a false interpretation of the term.
The proportions of the fund to be invested in relatively high-,
medium-, and low-yielding securities will depend upon the posi-
tion of the investor and his ability to assume risk. Similarly, the
proportion of the fund to be invested in securities of limited mar-
ketability will depend upon the individual situation. A substantial
part of the fund must necessarily be invested in marketable securi-
ties if the likelihood exists that the fund may have to be converted
into cash at short notice. The improbability of such development,
however, should not lead the investor to ignore the question of
marketability.
The diversification of an investment fund according to geo-
graphical boundaries affords more theoretical than actual advan-
127
tages. The investor who endeavors to practice national distribu-
tion finds the task complicated because of limited opportunities
in certain sections and because of the nationwide activities of the
more important companies. Only in the cases of investors with
extremely large funds, such as life insurance companies, is geo-
graphic diversification of practical value.7 To the average investor,
the principle of geographic diversification serves its purpose when
it prevents the concentration of investment in any one section.
Securities of the American Telephone and Telegraph Company
represent national diversification in themselves, just as securities
of the General Electric Company represent international diversi-
fication.
Diversification according to income payment dates is based
upon the fact that bond interest is generally paid semiannually
and stock dividends quarterly. It thus becomes possible to arrange
a fund in such fashion that an approximately equal amount of
income is receivable monthly or quarterly. It is questionable, how-
ever, if the slight advantage gained in this way offsets the addi-
tional work involved in the selection of such securities with vary-
ing payment dates.
Diversification according to maturity dates endeavors to mini-
mize the losses which may be involved in reinvestment. Large
maturities are inconvenient in years of low interest rates, since
the new securities bought with the proceeds of maturing obliga-
tions will give a less satisfactory rate of return. Large investors
endeavor to distribute maturity dates in order to avoid concen-
tration in any particular years and generally refer to their Tnaturity
calendars before buying new issues. The average investor will
usually find it more convenient to distribute his holdings into the
three chronological groups of short-term (up to five years), me-
dium-term (five to twenty years), and long-term (over twenty
years), limiting his commitment in any group to 40 per cent of
his fund.
The size of the investment unit should be proportionate to the
amount in the fund. A fund of $100,000 might reasonably com-
7 Geographic diversification is a normal by-product in the average investment
account. Exceptional is the case of a large fund that had 85 per cent invested in
securities located in a single state. Prudent investment policy should precede state
loyalty in such a case.
128
prise 20 different securities averaging $5,000 ( 5 per cent), with a
maximum of $10,000 (10 per cent) and a minimum of $2,000 (2
per cent) in any single issue. A fund of $1,000,000 might comprise
50 securities averaging $20,000 (2 per cent), with a maximum of
$50,000 ( 5 per cent) and a minimum of $10,000 (1 per cent). A
fund of $10,000,000 might comprise 100 securities averaging
$100,000 (1 per cent), with a maximum of $250,000 ( 2K per cent)
and a minimum of $50,000 ()z of 1 per cent).8 These limits are
suggestions only and would not, of course, be rigidly applied in
all cases.
The achievement of a satisfactory degree of diversification by
direct investment of a fund of relatively small size is practically
impossible. Fortunately there are several media for indirect in-
vestment of small funds, such as the investment company, that
enable even the investor of limited means to obtain diversification
that he could not obtain alone.
5. Continuous management and supervision. The management
of an investment fund that includes securities necessitates a de-
gree of care and prudence equal to, if not exceeding, that required
in the purchase of securities. Conditions are always changing,
with material influence upon investment values. Securities that
appear to be in an impregnable position at the time of purchase
may become highly speculative in the short space of a few years.
Events, such as wars, earthquakes, political upheavals, crop dis-
asters, and many others, may adversely affect security values over-
night. To a major extent, these factors are uncontrollable and
therefore unpredictable. Investment policy must be sufficiently
flexible to permit ready adjustment to the unexpected. The ex-
perience of recent years has taught the invaluable lesson that a
rigid investment policy is unwise procedure. No investment policy
should assume that occasional losses are avoidable or that the
intrinsic value of any security is not subject to change. Various ele-
ments of risk are present in all investments; they are magnified
in the case of securities and especially formidable in the case of
equities. A plan of continuous scrutiny and management should
be worked out, not only to guard against loss and to take advan-
8 An extreme case of diversification carried to an absurd extent was a fund of
$130,000 comprising 120 different securities. The disadvantage involved in the
management of such a fund offsets the benefit that diversification might provide.
129
tage of favorable exchange opportunities, but to keep the in-
vestor's fund in line with his changing needs and goals and with
conditions which affect his status but over which he has little or
no control.
The importance of vigilance in the management of an invest-
ment fund was admirably stated in a report of the Carnegie Cor-
poration as follows:
The funds of a great endowment can be kept intact only by a sys-
tematic revision month by month of all the securities of the endowment
and by a continuous process of sale and exchange, as circumstances
may affect the financial soundness of this or that security which the
trust holds.
Circumstances are continually arising to change investment
values collectively and separately. Some industries enter the stage
of expansion as others fall into decline. One company prospers at
a time when other firms in the same field are operating under
deficits. Investment popularity swings from one type of security
or enterprise to another. As the old order gives way to the new,
values in the less popular fields decline as prices in the more inter-
esting groups advance. While diversification tends to minimize
the losses often sustained in these changes, the sale of securities
which face unpromising prospects is even more effective as a
safeguard against depreciation.
Security exchanging is an important phase of investment man-
agement. The once popular theory that some securities were
adequately safe for investors to "buy and forget" has been invali-
dated in the experience of recent years. Neglect of a regular
scrutiny of investment holdings does more than result in the loss
of favorable exchange opportunities; it may lead to a most serious
decline in the aggregate value of the fund. As with diversification,
however, exchanging may be overdone, as happens when it de-
velops into promiscuous trading. An exchange of securities is
justifiable only when the position of the investor is improved as
a result. The conditions under which such betterment is possible
are not many:
1. Greater safety at the same yield.
2. Higher yield with equal safety.
3. Greater marketability at the same yield.
130
4. Improved tax position.
5, Improved diversification.
.6. Better appreciation opportunity.
As no two securities have the same quality, it naturally follows
that exchange opportunities are constantly afforded to the vigilant
investor. His principal concern is to be assured that the advantage
to be gained in one respect is not more than offset in the sacrifice
necessitated elsewhere. If all security buyers were purely inves-
tors, exchange opportunities would be fewer; but since prices are
influenced by speculators who have little interest in the income
aspect, investors often find good exchange opportunities. As yield
does not always vary with quality, because of the presence of such
technical factors as seasoning, convertibility, marketability, tax-
ability, legal status, and redemption option, investors who are
cognizant of these features are frequently in a position to make
advantageous exchanges resulting in an enhanced rate of return
upon their securities.
The average investor has limited opportunity to follow the
trend of the investment market and thus to keep closely in touch
with the position of his securities. He should endeavor, however,
to keep posted to the following extent.
1. Current quotations on all securities should be secured at
least monthly. Unusual changes should be investigated as possible
portents of serious developments.
2. Corporate earnings reports should be scrutinized on a com-
parative basis. These reports are generally published quarterly
and afford a continuous check upon the prosperity of the enter-
prise.
3. Changes in management should be carefully observed. The
more important the changes are, the more significant the results
may be.
4. External factors, such as the enactment of important legis-
lation, the development of new industries, and the trend of busi-
ness activity, directly influence investment values. The problem
of the investor is to relate these developments to the particular
securities which he is holding.
Regardless of the degree to which the investor may be deter-
mined to manage his own financial affairs, he should take advan-
131
tage of the advice and services of others in whom he has confi-
dence. It is common practice to submit security lists for periodic
inspection to brokerage houses, who may be expected to make
suggestions for portfolio changes in return for the commission
business involved. Only firms of the highest reputation should be
consulted, and the investor should always be prepared to review
any suggestions for change in the light of his own requirements.
Management of investments by others. The important and
vexing problems of selection (and diversification), timing, and
supervision may be passed along to others, at a cost, of course.
Freedom from care and a high degree of safety (at the expense
of income) are provided by institutions of the savings type, as
described in Chapters 3 and 4. These institutions also provide
diversification to their creditors, although the type and degree of
diversification depend on the institution selected for savings. No
protection against inflation is obtained.
Insofar as transfer of responsibility in investment in securities
is concerned, the common trust fund (Chapter 10), the invest-
ment company or fund (Chapter 29), and the fire and casualty
insurance company (Chapter 28) relieve the investor of manage-
ment, except that in the case of the last two, decisions must still be
made concerning the selection of the fund and the timing of the
purchase or sale of its shares. The natural and proper inclination
of trustees to operate a common trust fund conservatively gives
the beneficiary of such a fund lower income and less appreciation
than he might possibly obtain alone. But diversification, superior
stability, and some protection against inflation, together with the
important quality of freedom from care, give the common trust
fund a strong appeal to many investors seeking these require-
ments. The portfolios of these funds are seldom published and
the results of their management can be obtained only by direct
inquiry. On the other hand, the portfolio and record of all prop-
erty insurance companies and investment companies are always
available. As will be indicated in the chapter devoted to these
institutions, investment companies differ widely with respect to
investment goals and policy. Some are designed to obtain reason-
able income and considerable stability. Others are frankly oper-
ated for capital appreciation. The goals of the investor, the in-
vestment requirements that should be fulfilled, and the risks that
132
can be undertaken are factors that must be considered, together
with the record of its management, in the choice of any fund.
The tremendous growth of investment funds in recent years at-
tests the desire of many investors to transfer their investment
problems to others.
The professional investment counsel or adviser also stands
ready to take the responsibility for investment management, but
at fees which are likely to make his services prohibitive for the
small investor. For those that can afford their advice, the invest-
ment advisers are prepared to tailor the investment programs of
their clients to their individual needs, balancing the several factors
of income, preservation of principal, appreciation, tax matters,
diversification, inflation hedging (and the possibility of subse-
quent deflation) in one co-ordinated pattern. For the most part,
the well-established counsel firms are careful not to promise too
much and lean toward conservation and long-run over-all results
rather than toward spectacular performance. This is as it should
be.
Other methods of transferring managerial responsibility on a
fee basis include the investment departments of large banks and
trust companies and the supervisory services of some of the larger
Stock Exchange firms. In any case, the investor should know his
own needs and risks thoroughly so that he can understand and
approve the decisions of those experts to whom he transfers the
main responsibility for investment management.
Safekeeping of securities. Security instruments should be care-
fully guarded through deposit in a protected place. Bonds and
stock certificates should preferably be kept in a locked metallic
box, either in a bank vault or in a safe. Most banks offer safe-
deposit-box service at a low annual rental. A duplicate list of the
securities should be prepared (one to remain in the box) showing
the number of each security, the amount, the name, the maturity
date, and the rate and dates of income payments. Stock certificates
should be transferred into the name of the new owner upon de-
livery. Bonds bought for long-term holding should be registered
in full, or at least as to principal. No writing or marks of any kind,
other than endorsements, should be made on security instruments.
If a security is lost, notice with full description should be sent
immediately to the issuing corporation and also to the firm through
133
which it was purchased. Bond coupons should not be detached
prior to due dates.
Investors who desire to be relieved of the detail involved in
the handling and care of securities may establish custodian ac-
counts with banking institutions. In this event, the bank, for an
appropriate fee, handles all of the details under instructions from
the investor. The securities of each investor are kept in a segre-
gated group, apart from the general assets of the bank. The ser-
vices provided by the bank include the following:
1. Collection of interest, dividends, and principal.
2. Purchase and sale of securities.
3. Rendition of periodical statements of the account.
4. Provision of income tax information.
5. Special reports on securities held.
6. Information on called bonds, stock rights, protective com-
mittees, and sinking fund offers.
The advantage of a custodian account is that of convenience
as well as of safety. In the event of sickness or absence from home,
the securities are available for use of the owner, through letter,
telegram, or cable instructions to deliver, sell, or pledge as col-
lateral for a loan. Obviously, however, since the bank has full
access to the securities, the institution with which the account
is placed should be of unquestioned financial responsibility.
CHAPTER 9
INSTITUTIONAL INVESTORS
Scope. The purpose of this and the following chapter is to dis-
cuss the investment policies and practices of the more important
financial institutions of the country. The order of discussion is in
Chapter 9, (1) commercial banks, (2) mutual savings banks,
(3) savings and loan associations; in Chapter 10: (4) trusts,
(5) endowments, and (6) life insurance companies. Discussion
of the investment policies of two other types of financial institu-
tionsinvestment companies and fire insurance companies- is
postponed until later chapters (Chapters 28 and 29). The reasons
for the special treatment of these two types of institutions are,
first, that they lack the trust characteristics of the other institutions
and have a much wider leeway in the selection of their invest-
ments, and, second, that their own investment policies determine
to a large extent the investment appeal of the securities they them-
selves have issued. It seems more appropriate, then, to discuss
the management of the funds of these institutions in connection
with the analysis of their shares.
The general nature of commercial banks, savings banks, and
savings and loan associations has already been indicated in Chap-
ter 3. The material in the present chapter will therefore be con-
fined to the management of their investment portfolios.
The investment policies of financial institutions hold much in-
terest and importance for the individuals who use such institutions
as indirect means of investment. Adequate attention to the sub-
ject of institutional 'investments is therefore justified in a work
primarily directed toward the management of funds on the part
of individuals.
Restrictions on institutional investment. The common feature
that characterizes the institutions discussed in this and the follow-
ing chapter is that they act in a position of trust, investing not
134
135
their own money, but the funds of others entrusted to their care.
It naturally follows that such a position requires a degree of
prudence and caution beyond that which the individuals might
employ in the selection of their own commitments.
The latitude within which such institutions mav exercise dis-
cretion depends upon the nature of the contract or trust, the
powers granted by the contract or by the maker of a trust, and
the various Federal and state laws governing the investment
policy of fiduciary and similar institutions. Commercial banks,
savings banks, savings and loan associations, trustees, and life
insurance companies are obliged to observe strict regulations con-
cerning the securities and other investments that are legally eli-
gible for them to purchase, although in the case of trustees, the
individual trust arrangements may provide for considerable lati-
tude. On the other hand, educational and other endowments are
governed solely by their own investment policies or self-imposed
conditions. And owing to separate legislative acts, a particular
security which may be a "legal investment" for one class of institu-
tion may be ineligible for another.
1. Commercial Bank Investments
Commercial banks as investors. Along with other financial in-
stitutions, commercial banks form a very important segment of
the investment market. As of December 31, 1950, all insured com-
mercial banks in the United States held securities other than
Federal, state, and local bonds totalling $4.2 billions. They owned
$61.0 billions of direct and guaranteed Federal debt, or nearly
24 per cent of the total then outstanding, and $7.9 billions of state
and municipal bonds, or about one-third of the total outstanding.1
The substantial holdings by commercial banks of corporate bonds
and their dominating position with respect to Federal, state, and
local debt place a tremendous responsibility on the shoulders of
bank management with respect to investment policy. To a very
real extent, banks are the guardians of national liquidity.
Types of bank assets. The assets of commercial banks consist
of three major types: (1) cash and balances with other banks,
136
including legal reserves (known as primary reserves), (2) earning
assets, consisting of loans and discounts and investments, and
(3) fixed assets. The earning assets can also be divided into three
other categories: (1) the secondary reserve, consisting of highly
liquid loans, such as bankers' acceptances, prime commercial
paper, and call loans, and short-term Treasury obligations, such
as bills and certificates; (2) the investment account or permanent
bond list; (3) other earning assets, consisting of commercial loans
and discounts and real estate loans. The secondary reserve should
be of such high quality and liquidity that it can be converted into
cash at any time without material loss.
In determining the relative proportion of assets to be placed
in each group, the bank faces the difficult problem of maintaining
liquidity and at the same time deriving a reasonable income. The
primary reserves are completely liquid but produce no income;
the secondary reserves are extremely liquid but pay a very small
rate of return. The bond account yields a higher return although
a modest one, as the securities are primarily government issues,
including "bank eligibles" and marketable issues; higher yields
are obtainable on corporate bonds but at the sacrifice of quality
and marketability. Commercial loans usually produce higher
yields but are not dependable sources of funds at very short no-
tice. Real estate loans provide favorable yields but are the least
liquid of the entire portfolio.
Investment restrictions. The investment policies of all com-
mercial banks that are members of the Federal Reserve System
are governed by Federal statute and the rulings of the Comp-
troller of the Currency. State banks that are not members of the
Federal Reserve System are governed by the banking laws of the
state where they are located. Because the member banks comprise
nearly 50 per cent of all commercial banks in the country and hold
85 per cent of the total commercial bank deposits, the following
discussion pertains to those banks (member) which are subject
to Federal regulations.
Commercial banks are not permitted to participate as principals
in the underwriting of corporate securities, although they may do
so with respect to Federal and municipal bonds. Commercial
banks are not permitted to purchase stocks of any kind, with the
137
exception of certain specific types.2 They may buy no convertible
bonds at a price above their value without the conversion feature.
They may buy no securities which are in default of either prin-
cipal or interest payments. They are prohibited from purchasing
securities in which the investment characteristics are distinctly
or predominantly speculative.
All securities held by a bank which are not specifically ex-
empted from regulation (such as Federal, state, and local bonds-
except revenue bonds) or which are not prohibited must qualify
as investment securities and must be readily marketable, that is,
have such a market as to render sales at fair values readily avail-
able. Evidence of marketability must exist in either (a) public!
distribution of the particular issue or (b) public distribution of
other issues of the obligor. If there has been no public obligor,
eligible bonds are limited to ten-year (or shorter) obligations of
established enterprises, having sound values, under an acceptable
sinking fund plan of amortization. Where the above tests are met,
not more than 10 per cent of the unimpaired capital and surplus
of the bank may be invested in the securities of any one obligor.
If the purchase price is above par, the premium must be regu-
larlv amortized. Profits from the sale of securities must not be
considered as earnings until adequate reserves for actual or
estimated losses have been provided.
For purposes of bank examination (and, in the case of the first
Group named below, for the guidance of banks), securities are
divided into four groups according to quality. All eligible securi-
ties are placed in Group I and are valued on the basis of cost, less
amortization if any. Securities of investment quality include
general market obligations rated in the first four groups by the
recognized investment services: Aaa, Aa, A, and Baa; A1+, Al,
A, and B1+. (While such ratings are valuable, they should not
be a complete substitution for a bank's own judgment concerning
the quality of an issue.) Securities in Group II are predominantly
2 Up to 15 per cent of capital and surplus may be invested in the stock of a
company engaged in the safe-deposit business. Stock of a company holding prop-
erty necessary for banking purposes may be acquired. Under certain circum-
stances, up to 10 per cent of capital and surplus may be invested in the stock of a
corporation engaged in foreign banking. In addition, all member banks must
subscribe to Federal Reserve Bank stock.
138
speculative in character and are valued at the average market
price for the 18 months preceding the examination. At least 50 per
cent of the net depreciation, if any, must be deducted from the
capital of the bank in determining its solvency. Group III consists
of securities in default; these must be immediately written down
to market value. Group IV consists of stocks and similar holdings.
All depreciation on them is considered a loss and must be written
off against capital immediately (a bank may have acquired stock
through foreclosure of a collateral loan).
Significance of investments as assets. The role of investments as
bank assets has changed greatly in the past two decades, as indi-
cated by the following figures for all Federal Reserve Member
banks in the United States as of December 31 (in billions of
dollars): 3
1930 1950
Amount Per Cent Amount Per Cent
Loans:
Security loans $ 9.5 27.2% $ 2.7 2.5%
Commercial and agricultural
loans (including open-mar-
ket paper) 10.6 30.4 22.3 20.7
Real estate loans 3.2 9.2 10.5 9.7
Other -Ji 1.7 9.8 9.1
Total loans $23.9 68.5% $ 45.3 42.0%
Investments:
United States Government ob-
ligations $ 4.1 11.8% $ 52.4 48.5%
Other 6.9 19.7 10.3 9.5
Total investments $11.0 31.5% $ 62.7 58.0%
Total loans and investments .. . $34.9 100.0% $108.0 I007o%
* Net before valuation reserves.
During the 1930's, the dearth of commercial loans and the de-
sire of the banks for liquidity following the banking crisis led to
a marked shift from loans to investments, especially United States
obligations. During World War II, in spite of an increase in busi-
ness loans, the trend toward government securities was accentu-
ated by the role of the banks in financing the war effort. Ry the
end of 1950, 48.5 per cent of member banks' earning assets were
in investments, and of these investments Federal obligations com-
prised 83.6 per cent.
139
Although the yield on them is low, especially on the short-term
issues, Federal obligations bulk large in bank portfolios because
they possess several attractive features: (1) they enjoy the least
credit risk: (2) they involve no risk of substantial price fluctua-
tion; ( 3) they have liquidity in the market or elsewhere; (4) they
may always be used for bank borrowings at the Federal Reserve
banks without payment of penalty rates; (5) they are preferred
over all other investments by bank examiners and other super-
visory authorities. Within its government bond portfolio, of course,
a bank has the problem of distributing maturities. Its policy in this
respect will affect its liquidity and its income.
Investment policies. The investment policy of a commercial
bank is governed by regulation and by considerations of income
and risk. In the purchase of securities other than United States
government obligations, the main objective is to obtain an in-
creased return over that available in the comparable maturities in
the government market. But such an increased return carries with
it increased risk from possible unwise selection and subsequent
market declines. The factors that help to shape investment policy
mav be outlined as follows:
1. The nature of the deposit liabilities. Banks which normally
carry large demand deposits, especially banks which act as deposi-
tories for other banks, must maintain a higher degree of liquidity
than those in which time deposits predominate or whose demand
deposits are unusually stable. Such liquidity is reflected in a
higher proportion of short-term government securities among the
earning assets.
2. The relationship between deposits and capital funds. Banks
normally have a net worth that is very small in relation to assets,
as compared with business firms. The capital (stock), undivided
profits, and surplus that comprise the net worth represent the
protection afforded by the owners to the depositors. The lower
the ratio of net worth to deposits, the greater the risk and hence
the greater the need for liquidity through high quality and short
maturity. The appropriate capital funds-to-deposits ratio was
formerly considered to be in the neighborhood of 10 per cent. At
the end of 1950, the ratio stood at 7.4 per cent for all commercial
banks in the United States. National banks showed a ratio of 7.1
per cent, state banks showed 8.0 per cent, and, because of their
140 INSTITUTIONAL INVESTORS
importance as correspondent banks, banks in New York and other
leading cities showed a ratio of 8.6 per cent.4 Such ratios are
justifiable only as long as commercial banks remain very liquid.
3. The bank's other assets. Closely allied to the previous factor
is the amount and character of the bank's assets other than its
highly liquid investments. If assets "at risk"that is, loans and
discounts exclusive of open-market paper, and longer-term in-
vestmentsbulk large among the earning assets, the risk element
in the investment program must be kept at a minimum through
emphasis on higher quality and shorter maturities in the bond
account.
4. The bank's earnings requirements. This factor is placed last
because a bank's investment policy must always be based first on
considerations of safety and only second on considerations of in-
come. Yet a bank is organized with the objective of earning an
attractive rate on the investment of its stockholders. Its first re-
sponsibility is to its depositors, but it must also justify its existence
by producing a reasonable return for its owners. High risk and
high earnings go hand in hand (at least until disaster strikes);
low risk-taking produces low returns. To strike the proper medium
between these extremes is the central problem of banking. The
relation of capital funds to deposits, the character of the deposits,
and the type of services rendered by the bank all affect the degree
of risk that it assumes; the same factors also determine its earning
power. When, in order to produce satisfactory earnings, the cash
position of a bank is reduced, or loans and investments of longer
maturity or of lower quality are acquired, or deposits are greatly
increased, the interests of the stockholders and those of the de-
positors must be balanced with unusual ingenuity.
The market value of the bonds held in a bank's investment
account may decline, either through a decline in the investment
standing of the borrower or through a rise in prevailing money
rates that is reflected in declining prices of bondseven those of
"money bonds" of the highest quality.5 Banks seek to guard
against the first of these risks by purchasing and holding bonds
4 Compiled from group data in Federal Reserve Bulletin.
5 This influence was well illustrated in 1951, when, following the "unpegging"
of the price of long-term Treasury bonds by the Federal Reserve, the yield on
these bonds increased from 2.4 to 2.7 per cent.
141
of obligors of the highest credit standing. But they have no con-
trol over the second influence. They can offset it, however, by a
system of staggered or spaced maturities or the proper distribu-
tion of their holdings in short-, medium-, or long-term obligations.
As time passes, securities move steadily into the short-term cate-
gory. A maturity program requires prediction as to the course of
interest rates. If a rise is expected, banks prefer shorter maturities
to avoid the expected depreciation; if interest rates are expected
to decline, longer-term bonds are preferred. Such decisions ex-
plain in part at least why banks, with their tremendous investment
in government bonds, are extremely interested in and concerned
with the policy of the Federal government toward money rates in
general and the rates on Federal obligations in particular.
Profits and losses on securities. Bonds should be bought by
banks for income, not for capital gain. This does not mean that
banks must hold all bonds to maturity. Constant reappraisal of
bond holdings and the need to diversify maturities, as well as the
use of bonds to feed the secondary and even the primary reserve
when necessary, create a certain turnover in the bond account.
Banks thus incur profits and losses in securities even though short-
term trading is ordinarily avoided as a definite policy.
The regulations of the Comptroller of the Currency require
banks to use any profits realized in the sale of securities to offset
actual losses and provide reserves for possible future losses before
such profits may be included as income. In seven of the ten years
1941-1950 inclusive, losses and charge-offs of member banks ex-
ceeded recoveries and realized profits on securities.6
Other bank investments. Discussion of the loaning activities of
commercial banks would involve a digression into commercial
bank management too extensive for the purposes of this volume.
There are, however, two types of loans that, because of their
longer maturity, properly belong in a discussion of bank invest-
ments, namely, term loans and real estate mortgages.
Term loans are business loans for capital purposes running up
to ten years in maturity and amortized by regular installments
during their life. This type of intermediate credit was developed
in the later 1930's, when banks had surplus funds not in demand
See pp. 521, 529 for a discussion of bank earnings derived from investments.
142
on the part of short-term borrowers. They became increasingly
important during the war years, although since 1948 there seems
to have been a tendency for business to resort more to shorter-
term credits for working capital purposes.
The typical term loan is expected to be repaid out of future
earnings, and contains written covenants on the part of the bor-
rower to conduct his financial affairs in a manner agreed upon by
the borrower and the lender, such as restrictions on other debt and
on dividend distributions. It is usually secured, although the
larger term loan is less likely to be secured than is the small one.
Studies of term loans as of 1946 revealed that these credits were
a very important factor in the credit supply.7 It is estimated that
$4.6 billions of term loans to member banks were outstanding
near the end of 1946, representing 144,000 separate contracts.
They amounted to one-fifth of the number and one-third of the
dollar amount of all member bank loans outstanding to business
concerns. While more recent data are not available, it is likely
that term loans have declined somewhat in relative importance.
Term loans appear to be a substitute for two other types of
bank earning assets that have declined in importance (for banks)
in recent years. One is the short-term loan that was almost auto-
matically renewed if the borrower's credit standing remained
satisfactory. The other is the corporate bond or debenture. While
loans of maturity of from one to ten years violate the traditional
theory of bank liquidity, experience has demonstrated their use-
fulness provided they are made wisely and are followed and
collected carefully, and provided that the bank is otherwise liquid.
They make possible the employment at attractive rates of funds
that might otherwise be idle. In 1945 the Association of Reserve
City Bankers reported that "from the standpoint of collections,
the experience of the commercial banks has been impressive.
While term lending has yet to be tested by a long and protracted
depression, the sharp contraction of 1937-38 created no serious
defaults. Up to the present time losses have been negligible and
the loans have proved satisfactory and profitable." 8
7 See A. R. Koch, "Business Loans of Member Banks," Federal Reserve Bulletin,
March, 1947, and Don Holthausen, "Term Lending to Business by Commercial
Banks in 1946," Federal Reserve Bulletin, May, 1947.
"Term Lending by Commercial Banks. Prepared by the Association of Reserve
City Bankers (April, 1945).
143
Real estate loans, along with term loans, are appropriate invest-
ments for saving deposits which have much less volatility than
those in the demand category. They have played an important
role in the activity of commercial banks, although at present they
are far less significant than the total holdings of government and
corporate bonds.
The experience of banks with real estate mortgage loans in the
1930s was not a happy one, especially for smaller banks. Since
that time, practices have been greatly improved by experience
and by regulation. National banks may buy any mortgage insured
by the Federal Housing Administration or guaranteed by the
Veterans' Administration. In addition, they may buy other first
mortgages not exceeding 60 per cent of the appraised value of the
security and with a maturity of 10 years, provided 40 per cent of
the loan is to be amortized within that time; single-maturity
loans are limited to 50 per cent of appraised value and a maturity
of five years. A national bank may make mortgage loans in the
aggregate up to either the amount of its unimpaired capital and
surplus or 60 per cent of its time and savings deposits, whichever
is the greater.
The amortization features of modern real estate loans, and espe-
cially the insurance or guarantee by Federal agencies of loans
qualified for such insurance have done much to put mortgages
back into the class of respectable bank assets. Their inherent lack
of liquidity is mitigated by the fact that banks can now obtain
special four-month advances against mortgages from the Federal
Reserve banks, and by the fact that FHA-insured mortgages may
be sold to the Federal National Mortgage Association. In the
event of default, insured mortgages are exchanged for govern-
ment-guaranteed debentures of the Federal Housing Administra-
tion."
2. Savings Bank Investments
General investment restrictions. The general characteristics of
savings banks described early in this book (Chapter 3) help to
explain why these institutions have somewhat less need for li-
quidity than commercial banks, and therefore why their cash and
reserve requirements are lower and why their investments may
A more complete discussion of mortgage loans is found in Chapter 30.
144
include a greater proportion of longer-maturity instruments. The
savings bank can invest savings funds in securities of limited
marketability and in home mortgages that are adequately safe
and that yet pay a higher rate of income than do the more market-
able and short-term securities.
But there should be no compromise with safety in the invest-
ment of savings bank funds. The purposes for which savings banks
have been established have led the legislatures in the states in
which these banks operate to impose restrictions on their invest-
ment powers. The theory is to assure the holding of high-grade
investments only, including real estate mortgages, government
bonds, railroad obligations, and public utility bonds. Such a selec-
tion may provide safety but lack flexibility. Nevertheless, state
legislatures have been slow to liberalize savings bank investment
laws, on the ground that to do so might jeopardize the savings of
the low-income classes.
States which have taken the lead in revising the "legal list" for
savings banks include New York and New Jersey. In New York,
following the great decline in the earnings of the railroad industry,
it was necessary in 1931 to suspend the criteria applicable to
eligible railroad investments to prevent the decimation of this
portion of the legal list, and in 1938 less severe requirements were
permanently applied to railway bonds. In 1938, provisions were
added permitting the purchase of issues not specified in the statu-
tory investment provisions, under certain conditions. Thus, some
high-grade industrial bonds became eligible for purchase. In 1946
New Jersey introduced a new yardstick for qualifying railroad
bonds as legal investments.
Much criticism has been directed toward the rigidity of the
"legal list" requirements and the difficulty of setting up adequate
tests that would hold under varying conditions. Some have advo-
cated the application of the prudent man rule similar to that
adopted in many states with respect to trustee investments. It is
debatable, however, whether as much discretion should be given
the institution holding the funds of small savers payable (except
under unusual conditions) on demand as is given to investors of
funds accumulated primarily for the purpose of yielding an in-
come and held over a period of years. At the present time, 15 of
the 17 states where mutual savings banks operate allow savings
145
banks less latitude than trustees with respect to the selection of
investments.
Legal investments in New York State. No two states have a uni-
form law regarding the eligibility of securities for savings banks.
Because the New York law is representative of fairly conservative
legislation and has served as a model for a number of other states,
the present "legal list" in New York is set forth below. While the
New York list has not provided complete protection against in-
vestment losses, as the record of eligible railroad bonds during the
1930's plainly shows, the solvency record of New York savings
banks is sufficient testimony to the efficiency of the law. Not only
did no savings bank fail in New York during the banking crisis of
1932-1933, but no savings bank has failed in New York during the
past forty years, and no depositor in a New York State savings
bank has lost money by reason of the failure of the bank during
the present century.
A brief summary of the types of securities which are legal in-
vestments in New York is here given. An official list of the specific
securities which are regarded as eligible is prepared by the State
Banking Department and issued at the beginning of July in each
year.10 Under Section 235 of the New York Banking Law, savings
banks in New York State may invest only in the following types
of securities:
1. Direct and guaranteed obligations of the United States.
2. Obligations issued or guaranteed by the International Bank
for Reconstruction and Development.
3. Bonds of New York State based on full faith and credit.
4. Bonds of other states in the United States and of Hawaii
based on full faith and credit.
5. Direct obligations of New York State municipalities.
6. (a) Bonds of certain counties, cities, and school districts in
adjoining states, having a minimum population of 10,000 and a
maximum net debt ratio of 12 per cent of real property valuation
and having had no default within 25 years.
(b) Bonds of certain counties, cities, and school districts in
10 A convenient source of reference on New York and other states is provided
in the semiannual State and Municipal Compendium of The Commercial and Fi-
nancial Chronicle. See also Moody's Manual of Investments: Governments and
Municipals.
146
nonadjoining states, having a minimum population of 30,000 and
a maximum net debt ratio of 12 per cent of real property valuation
and having had no default within 25 years,
(c) Bonds of any city in the United States that has taxable
real property in excess of $200,000,000, a minimum population of
150,000, and no tax-limit legislation in effect.
(d) Bonds of counties, cities, and school districts outside of
New York State issued after December 31, 1938, must not be sub-
ject to any tax-limit legislation which does not exclude debt
service.
7. Bonds and mortgages on unencumbered real property situ-
ated in New York State up to 60 per cent of appraised value on
nonresidential property, up to 66% per cent on residential property,
and up to 80 per cent of the first $10,000 of appraised value and
50 per cent of the remainder on 20-year amortized single-family
residences.
8. Insured FHA bonds and mortgages on real property in New
York State or in any adjoining state.
9. (a) Mortgage bonds of certain domestic railroad companies,
direct or assumed, including equipment trusts, which have at least
500 miles of line, have annual revenues of at least $10,000;000;
have earned fixed charges at least one and one-half times in pre-
vious year and in five out of six previous years, have paid cash
dividends equal to one-fourth of fixed charges or earned fixed
charges at least one and one-half times in previous year and in
nine out of ten previous years, and have had no default in the past
six years. (This provision was nonoperative from 1931 to 1938
with respect to bonds previously legal. Subsequent to 1938, bonds
had to show fixed charges earned at least once in five out of six
test years preceding investment under a moratorium which ex-
tended until 1941.) 11
(b) Other bonds and debentures of companies included in the
preceding paragraph which show all charges earned at least two
times in previous year and in five out of six previous years, and
which show a net income of $10,000,000 after all charges have
been deducted.
11 A striking picture of the decline in the position of railroad bonds is shown in
the statement that approximately $7.6 billions in par value railroad bonds were
"legal" in 1931 and less than $1.0 billion were eligible on the same basis in 1939.
INSTITUTIONAL INVESTORS 147
10. Bonds of the Savings and Loan Bank of the State of New
York.
11. Consolidated debenture bonds of the Federal Land Banks,
Federal Home Loan Banks, and Federal Intermediate Credit
Banks.
12. Mortgage bonds of certain domestic electric and gas com-
panies that have annual operating revenues of at least $2,000,000,
have earned fixed charges at least two times in previous year and
2% times on an average basis for five previous years. The total of
capital stock, any premiums thereon, and surplus must be at least
equal to two-thirds of the debt. The bonds must be part of a
minimum issue of $1,000,000, and must represent a first or refund-
ing mortgage not exceeding 75 per cent of the value of the physi-
cal property pledged.
13. Bonds of certain domestic telephone companies that have
annual operating revenues of at least $5,000,000, have earned
fixed charges at least two times in previous year and on an average
basis for five previous years. Bonds may be secured or unsecured,
but in any event capital stock, premiums thereon, and surplus
must at least equal two-thirds of aggregate funded debt. As in the
case of other corporate bonds, such terms as "funded debt" and
"net earnings" are carefully defined in the statute.
14. Corporate interest-bearing obligations not otherwise eligi-
ble, which, in the opinion of the State Banking Board, are suitable
investments for savings banks.
15. Stock in a Federal Reserve Bank and a Federal Home Loan
Bank in an amount required for membership.
16. Securities of any trust company or other corporation organ-
ized under the laws of New York State where all of the stock of
such companies is owned by not less than 20 savings banks, to the
extent authorized by the Banking Department.
17. Stock of New York State housing corporations under certain
conditions.
18. Obligations of various New York State public authorities.
The maximum proportion of total assets that may be invested
in certain of the preceding groups is as follows: real estate mort-
gages, 65 per cent (exclusive of FHA-insured and VA-guaranteed
mortgages); railroad obligations, 25 per cent; electric and gas
148
bonds, 25 per cent; telephone bonds, 25 per cent; real estate (for
transaction of business), 25 per cent of surplus fund; housing
projects, 15 per cent (or 50 per cent of surplus fund).
The total face value of all securities on the legal list in New
York and other states, excluding United States Government obli-
gations and real estate mortgages, is enormous. Despite the eligi-
bility of a huge total of available securities, the savings banks of
the country had invested only 10 per cent of their total assets in
this group, having placed around 50 per cent in United States
Government securities and 40 per cent in real estate mortgages
at the beginning of 1951.12
Shifts in investment policy. During the 1930s, the experience
with mortgages and with corporate bonds, especially with railroad
obligations, led to a sharp contraction of these two types of in-
vestments of savings banks, and the marketability and favorable
yield on government bonds induced a substantial increase in the
holdings of these securities. During and following World War II,
governments became the most important investment, in spite of
their declining yields. As of December 31, 1950, mutual savings
banks held $10.9 billions, or, as indicated above, approximately
50 per cent of their total assets, in United States Government ob-
ligations. It was discovered in the depression years that, while
the need for liquidity was not so great as in the case of commercial
banks, contraction in savings bank deposits could be sharp. Al-
though the depression record of mutual savings banks was impres-
sive, and suspensions virtually unknown, after the bank holiday in
March, 1933, steps were taken to improve ability to meet large-
scale withdrawals. Government bonds provided the required li-
quidity, and the yield on very high-grade corporate bonds came
so close to that on governments as to make the latter particularly
attractive, especially the longer-term issues. Other precautions
were also taken to enable them to raise large amounts of money in
case of need, including membership in the Federal Deposit In-
surance Corporation. At the end of 1950, 194, or 37 per cent, of
the 529 mutual savings banks were insured by the Corporation;
these insured banks held 71 per cent of the deposits of all mutual
banks.13
12 Annual Report of the Comptroller of the Currency, 1950, p. 162.
13 Annual Report of the Federal Deposit Insurance Corporation, 1950, p. 56.
149
3. Investments of Savings and Loan Associations
General investment characteristics. The general nature of sav-
ings and loan associations was indicated in an earlier chapter. It
was seen that their functions are (1) to act as a location for
savings and (2) to lend on home mortgages. The association is
the only specialized homeowner credit institution in the American
financial system. More than 11,000,000 persons have saved or
invested funds aggregating over $14 billions in the more than
6,000 savings and loan associations throughout the United States.
While these institutions are technically not depositories, they are
so regarded by their account-holders. It is important that their
assets be sound and that reasonable liquidity be maintained, al-
though the need for liquidity is not so urgent as in the case of
banks.
Since the chief function of the association is to lend on home
mortgages, it is not surprising to find that such investments com-
prise between 70 and 80 per cent of total assets. Most of the
balance is held in cash or in obligations of the United States Gov-
ernment. The associations made 32 per cent of all of the "GI"
home loans made to World War II veterans during the period
1944-1950, and they are currently the source of about one-third
of all home loans obtained by all types of borrowers.
The most important asset of the associations is the single-family
home loan. In addition, small flat buildings and some commercial
properties are included in the associations' lending operations.
Principal and interest usually are paid in monthly installments,
with maturities ranging from 12 to 25 years on installment loans,
at interest rates of from 4 to 6 per cent (except FHA and GI
loans), with 5 per cent being the most common rate.
In financing new construction, the typical ratio of the amount
of the loan to the purchase price is around 70 per cent, with typi-
cal maturities of 15 to 20 years. Throughout the savings associa-
tion field, the major portion of the lending to finance new
construction is represented by the conventional loan without the
aid of government insurance. The maturities of loans to finance
the purchase of existing homes average very considerably less
than 15 years, and FHA and GI loans are even less prominent.14
"See p. 597. .
150
Legal restrictions on investments. The investment of the share-
holders' money by Federal savings and loan associations and most
state-chartered institutions is substantially limited to monthly
amortized first-mortgage loans on homes and small apartments in
the immediate and surrounding communities and obligations of
the United States Government. In the case of Federal associations,
not more than 15 per cent of the assets may be invested in the
following types of loans combined: (1) loans in excess of $20,000;
(2) loans on improved real estate other than homes (large resi-
dential properties and commercial and industrial properties); (3)
loans on improved real estate outside of the association's lending
area (within a radius of 50 miles of the office); (4) non-install-
ment loans; (5) real estate owned other than the association
office. Guaranteed loans are exempt from these provisions. Loans
may be made on savings accounts, and small unsecured property-
improvement loans repayable in monthly installments within 5
years are permitted under certain conditions. Loans other than
the forementioned are therefore concentrated in monthly install-
ment loans on homes, not exceeding 80 per cent of value, with
maturities limited to 20 years, except for FHA-insured loans and
VA-guaranteed loans. This loan limit is substantially higher than
is permitted for banks and insurance companies.
The combined statement of condition of all operating savings
and loan associations in the United States, showing the break-
down of assets by major classes of investments, is given in Chap-
ter 3.
Secondary markets. The high degree of concentration of sav-
ings and loan associations investments in mortgages might appear
to be dangerous to the solvency of these institutions. But the type
of loans made, the amortization feature, and the availability of a
secondary market all contribute to soundness. This secondary
market exists in insurance companies and in the Federal agencies
which stand ready, as in the case of the Federal Home Loan
Banks, to lend on mortgages or, as in the case of the Federal Na-
tional Mortgage Association, to buy them. The latter organization,
now a constituent agency of the Housing and Home Finance
Agency, was formed for the purpose of establishing and maintain-
ing a market for mortgages on homes, including large-size hous-
INSTITUTIONAL INVESTORS 151
ing projects, insured by the Federal Housing Administration and
the Veterans' Administration. Since 1947, most of its purchases
have been VA loans; total purchases in 1950 were slightly in
excess of $1 billion.15
15 Housing and Home Finance Agency, Housing Statistics, January, 1951, p. 69.
CHAPTER 10
(CONTINUED)
4. Trustee Investments
Nature of a trust. A trust involves the passing of title to prop-
erty by deed or will (the estate) from an owner (the settloror
testator, in the case of a trust created by will) who creates the
trust to a trustee who is to hold the property for the benefit of
another, the beneficiary. There are many applications of the trust
principle. We are concerned here with the creation and adminis-
tration of trusts designed to produce income for the beneficiary,
who may be the trustor or another person or persons. The rela-
tionship between the trustee and the beneficiaries is strictly fidu-
ciary, and involves the highest degree of good faith and fidelity on
the part of the trustee and of confidence on the part of the creator
and the beneficiary.
Individual trusts are created for a variety of purposesfor the
support of dependents, the education of children, the support of
educational or charitable organizations, pension and profit-sharing
plans, retirement, to relieve the creator of the burden of manage-
ment of funds, and many others. Any legally competent person
may set up a trust by a simple agreement setting forth the identity
of the trustee or trustees, the manner in which the funds deposited
with the trustee shall be invested, the distribution of the income
from the estate, and the disposition of any principal to the re-
mainderman when the trust terminates.
Types of personal trusts. A trust created by will and which be-
comes effective upon the death of the testator is known as a
testamentary trust or trust under will. A living or voluntary trust
is created by deed or declaration and becomes effective during
the life of the maker, who may even designate himself as the
152
153
beneficiary. In a life insurance trust, the body of the trust consists
of life insurance policies on the life of the creator, the proceeds of
the policies being made payable to a trustee when due. The pur-
pose of this type of trust is to provide flexibility in arrangements
that will relieve the dependents of the responsibility of handling
and investing and possibly mismanaging substantial sums of
money. As an alternative to an insurance trust, the funds may be
left with the insurance company and distributed under various
settlement options; or the proceeds may be made payable to the
estate of the insured and thus pass into a testamentary trust
created under his will.
Corporate trustees. Although individuals may be named as
trustees, the grave responsibilities of the trust function and the
growing complexities of security and property management have
been influential in creating a trend toward the appointment of
corporate trustees, that is, of banks or trust companies as trustees.
State banks have long been permitted under special state laws
to act as trustees and to engage in other fiduciary activities. Na-
tional banks received this right in 1918, but not until they were
given perpetual existence in 1927 was it practical for them to
engage in trust activities. Most large state and national commer-
cial banks now have trust departments that perform a wide
variety of functions for individuals and corporations. Trust com-
panies as such were originally formed to act as incorporated
trustees. Gradually they took on commercial banking powers and
activities, and in most states trust companies are now permitted
by law to perform all the functions of a bank. Today there are
few trust companies without banking powers.
In the rendering of trust service, the corporate trustee offers a
number of advantages over the individual trustee that may be
summarized as follows:
1. Perpetual existence. Continuous administration of a trust is
important not only because the trust may extend over a long
period of years, but also because the interruption of the perform-
ance of trust dutiessay by the death of an individual trustee
involves legal and accounting complications, not to mention
possible changes in investment policy.
2. Financial responsibility. The corporate trustee, with its sub-
154
stantial resources, strict regulation, and segregation of trust assets,
provides financial assurance that most individual trustees could
not offer. Most states require trust companies and banks to deposit
security for the faithful performance of trust functions.
3. Business responsibility. A trust institution prospers only if it
provides satisfactory service. Thus, the trust institution has a com-
pelling incentive to efficiency and aggressiveness in caring for the
trust that may not exist in the case of an individual trustee.
4. Specialization. There is not only the advantage in a bank or
trust company that its trust department is experienced in the
handling of trust business. The bank or trust company also offers
the services of specialists in a large department as well as the
ancillary facilities of the banking department.
The growth of the activities of corporate trustees in the United
States is indicated by the following table. The data cover only
national banks and therefore exclude an equally impressive show-
ing for state banks.
TRUST OPERATIONS OF NATIONAL BANKS
Number of
Individual
Trusts
Individual
Trust
Assets
Year
Trust
Departments
1930
1,829
79,912
$ 4,473,040,926
1940
1,540
137,629
9,345,416,682
1950
1,518
191,874
34,597,174,122
Source: Annual Reports of the Comptroller of the Currency.
Based on the figures for national banks, it is estimated that in
1951 all trust departments in the United States held personal trust
property totalling $50 billions, or about $1 in trust assets for every
$3 of deposits.
Legal restrictions on trust investments. The investment policy
of the trustee is governed by the instructions, if any, in the trust
instrument. If investment powers are not specified, the trustee is
restricted to investments permitted by the laws of the state of
domicile. The instrument itself may designate the types of securi-
ties to be purchased or may impose restrictions or limitations. But
the trust agreement may provide for discretionary powers author-
izing the trustee to buy any securities he wishes, subject only to
155
the exercise of his prudent judgement. A third alternative is the
restriction to certain specific securities turned over at the incep-
tion of the trust or to be purchased by the trustee. It is particularly
important that testamentary trusts provide the greatest flexibility
in investment policy so that the trustee may fit the trust to the
needs of the beneficiaries and under changing conditions obtain
reasonable income commensurate with safety. It is equally im-
portant that a trust provide the trustee with adequate power of
sale and purchase.
State laws governing trust investment are far from uniform. In
some the "legal list" is strictly defined by a state board or com-
mission. In others only the general qualifications of legals are set
forth. In a growing number of states, however, the laws have
been liberalized or court decisions have been rendered to permit
the trustee to buy any securities, subject only to the "prudent
man" rule first set forth in Massachusetts over a century ago:
All that can be required of a trustee to invest is that he shall conduct
himself faithfully and exercise a sound discretion. He is to observe how
men of prudence, discretion and intelligence manage their own affairs,
not in regard to speculation, but in regard to the permanent disposition
of their funds, considering the probable income, as well as the probable
safety of the capital to be invested.1
Prior to 1950, New York State represented an example of the
strict type of statute. Trust investment was limited, with certain
minor exceptions, to the same kinds of securities and mortgages
in which savings banks of New York State were authorized to
invest, unless other forms of investments were specifically sanc-
tioned by the trustor. When, in 1950, New York followed the lead
of 24 other states, including Illinois, California, and Massachusetts,
to adopt the "prudent man" rule which gives the trustee wide
discretion in the selection of investments, a considerable impetus
to the use of common stocks for trust investment was felt. The
potentiality for such investments is indicated by the fact that in
the New York Federal Reserve District at the end of 1950 assets of
individual trusts administered by national banks alone totalled
$12.7 billions.2
1 Harvard College v. Armory, 9 Pickering 446 (1830).
2 Annual Report of the Comptroller of the Currency, 1950, p. 192.
156
Common stocks as trust investments. The traditional attitude
of trustees toward common stocks, with the exception of Massa-
chusetts and a few other states where equities have been looked
upon with favor for many years, is that they lack the stability of
income and market value that is required in a trust fund. Invest-
ment in stocks and in real estate was regarded as equivalent to
partnership in business ventures with the speculative risks that
such a position inevitably involved.
The trend toward the "prudent man" rule is explained by three
factors: (1) the low yields available on high-grade bonds and
other "legals"; (2) the rise in the cost of living and the need for
protecting the principal fund from the wasting effects of inflation;
and (3) the recognition of the greater income and the adequate
stability of a well-selected list of seasoned high-quality stocks.
Even before the "prudent man" rule was adopted in New York, a
very substantial proportion of the assets held by New York trusts
of the discretionary type consisted of common stock.
The new New York State law permits fiduciaries to invest up
to 35 per cent of restricted trust funds in "such securities as would
be acquired by prudent men of discretion and intelligence in such
matters who are seeking a reasonable income and the preservation
of their capital." Subject to the interpretation of "prudence,"
funds may be placed in bonds not on the legal list, as well as in
preferred and common stocks of domestic corporations. Except
for bank and insurance company stocks, only those common stocks
fully listed on a national securities exchange may be considered.
This new statute was preceded by a study which showed the com-
parative performance of 44 restricted and 89 unrestricted trusts
of 16 banks for which 1926 principal valuations were available.3
The unrestricted trusts showed a greater decline from 1929 valua-
tions but complete recovery by 1947; they also showed greater
stability of income and a higher average income over the period
than did the restricted trusts.
3 A Report by the Trust Investment Study Committee, Trust Division, New York
State Bankers Association, 1949. In addition to a study of the performance of a
sample of New York trusts, the report makes a thorough investigation of the per-
formance of the New York legal list and of the price record and rates of return
on various groups of bonds and stocks as represented by well-known averages. It
concludes with an illustrative statute that formed the prototype of the New York law
that became effective July 1, 1950.
157
The trend toward common stocks as trust investments will not
cause a great rush into the common stock field. Fiduciaries are
still limited by a long line of court decisions, precedents, and ex-
perience that will cause them to select only seasoned high-grade
stocks with long dividend records and above-average market sta-
bility. Trustees will still be obliged to exercise prudent care; but
their ability to keep their funds productive will, theoretically at
least, be enhanced by the expansion of the legal list. Only time will
show the results of the changes in law and investment policy.4
Common trusts. The matter of handling trusts of small size on
a profitable basis while obtaining safety and diversification has
long been a problem for trustees. Safety and liquidity may be ob-
tained by restricting such funds to high-grade bonds, with empha-
sis on United States Government obligations. But such a policy is
employed at a sacrifice of income and protection against inflation.
Another alternative that is rapidly growing in favor is the use of
the common trust, in which a number of trust funds are combined
for purposes of economy and efficiency of administration. Such
consolidated funds are permitted by legislation or court decision
in over 30 states. Although state banking institutions must operate
common trusts in accordance with the laws of the state in which
the bank is located, national banks must follow a uniform plan as
laid down by the Board of Governors of the Federal Reserve Sys-
tem. The maximum participation of any one fund is restricted to
$100,000 in order to limit the trust to small funds on which ad-
ministration expenses are relatively high and in which adequate
diversification of risk is difficult to obtain. The trust may not
invest more than 10 per cent of its assets in any single enterprise
other than United States Government securities. Cash and readily
marketable securities, defined as subject to frequent dealings in
ready markets, should comprise about 40 per cent of the trust.
Participations and withdrawals are permitted only on quarterly
valuation dates. Funds may not participate in a common trust if
any assets in the trust are illegal for the fund to hold or if the trust
agreement does not sanction the arrangement.
4 At the end of 1950, national banks had 65 per cent of their trust investments in
bonds, 23 per cent in stocks, 4 per tent in mortgages, and 8 per cent in real estate
and other investments. Annual Report of the Comptroller of the Currency, 1950,
p. J 93.
158
The common trust fund provides diversification and flexibility
not otherwise obtainable in small trusts, as well as the possibility
of a larger income. It is an innovation that many ultra-conservative
trust departments have been reluctant to adopt, but its use has
grown steadily. In a survey of such funds made in 1951, it was
reported that 117 common trust funds were then being operated
by banks and trust companies in 23 states and the District of Co-
lumbia. Seventy-three of these reported a total of $535.9 millions
invested, with an average fund of $7.3 millions. The investments
of these 73 funds, all of the "discretionary" type, were distributed
as follows: Government bonds, 35.0 per cent; other bonds, 9.3 per
cent; preferred stocks, 15.1 per cent; common stocks, 39.2 per cent;
cash and other assets, 1.4 per cent.5 If experience with such funds
proves favorable, and as the "prudent man" rule is extended and
put into operation, it is likely that the common trust fund will
become increasingly significant.
Investment procedure. The investment procedure of a trustee
is complicated by the fact that the wishes of not one or two but
often of three parties must be respectednamely, the trustor who
created the trust, the present beneficiaries who are entitled to the
income from the fund, and the ultimate beneficiaries who will
receive the principal of the fund at the expiration of the trust.
It is not uncommon for trustors to make restrictions that hamper
the trustee. In some cases, the trustee is required to hold certain
securities which might better be sold. In other cases, the trustee
is not given the power to purchase certain securities which in his
judgment would be appropriate for the purpose.
The present beneficiaries in a trust fund, who desire as high a
rate of income as might reasonably be expected, naturally object
to any attempt on the part of the trustees to buy only the very
safest securities, on which the rate of return is low. On the other
hand, the trustee must be mindful of the ultimate beneficiaries,
called "remaindermen," who are entitled to the principal of the
fund as nearly intact as conservative stewardship can preserve it.
Between the opposing viewpoints, the trustee must steer a middle
course, concentrating neither in the highest-grade issues with low
5 Trusts and Estates, June, 1951, p. 364.
159
yields nor in the low-grade issues with high yields. As safety of
principal is paramount, however, he must not go below medium-
grade issues and should prefer the higher-grade issues. In a market
where the yield on the best grade of long-term bonds is about 3
per cent, an average rate of return as high as 5 per cent would be
an unreasonable expectation from a conscientious trustee.
It is universally held that it is outside the duty of a trustee to
increase the value of a fund. Appreciation should be eliminated
on the general principle that, in testamentary cases at least, death
should end the risk of accumulation. The argument in favor of
common stocks for trust accounts should be settled on the basis
of income prospects rather than appreciation possibilities, unless
it is maintained that the duty of the trustee is to preserve purchas-
ing power as well as dollars.
Generalizations concerning the investment policy of trustees
are difficult if not impossible to make, because each fund differs
in size and in requirements from every other one. The emphasis is,
of course, on production of reasonable income and preservation of
principal, but within these general limitations many variations in
investment policy must be expected. Trust officers, by the very
nature of their fiduciary position, must always lean to the conser-
vative side.
5. Investment of Endowments
The endowed funds of charitable, religious, and educational
institutions are administered by trustees who are limited in their
investment policy only by the general obligation to maximize
income as far as is consistent with safety and (ordinarily) to pre-
serve the principal. They are not bound by the regulations gov-
erning the administration of trust funds of fiduciaries proper.
The administering of endowment funds need not provide for
more than moderate liquidity. The general goal is reasonable in-
come and full employment of funds, and marketability is of sec-
ondary importance. The tax status of securities is not an investment
consideration, since, being non-profit organizations, the income
from endowments is tax-exempt (at the time of writing). Nor is
capital appreciation as such an important goal, although through
the purchase of common stocks an approach is made toward
160
maintaining the purchasing power of the principal and income in
the face of rising prices.
The traditional investment policy of most endowments was to
emphasize bonds, preferred stocks, and mortgages, but in recent
years a decided shift toward investment in common stocks has
taken place. A survey of the investment policies of 59 educational
institutions in 1947 revealed that as of 1946, common stocks com-
prised 30 per cent of the book value of their endowments.6 A 1951
survey of 24 institutions shows common stocks at 40 per cent of
portfolios.7 The decline in income from senior securities, the rise
in costs of operation, and the decline in gifts, together with the
growing recognition of the investment qualities of well-selected
high-grade common stocks, are responsible for the trend toward
equities. As of 1950, Harvard University had 44 per cent of its
endowment in common stocks; the total fund produced an average
return of 3.7 per cent on book value. Stanford University had 39
per cent of its endowment investments in common stocks, and the
average return on investments in merged endowment funds was
4.3 per cent. Wesleyan University's exceptional return of 5.8 per
cent was attributable to the fact that 77.6 per cent of its endow-
ment was placed in common stocks.
Another interesting development in college and university fi-
nance has been the growing investment of endowment funds in
business enterprises and income-producing real estate, including
property acquired from business firms and leased back to the latter
under a sale-lease arrangement. Many colleges and universities
are very definitely in business. The surveys referred to above
indicate that about 10 per cent of total collegiate endowment is
now invested in this form.8 The figure suggests the efforts that are
being made to increase the rate of return on endowment in the
face of rising costs. The tax-exemption enjoyed on such property
is currently a matter of considerable controversy.
In the administration of their security portfolios, some institu-
tions have turned to the use of formula timing plans as guides for
the switching from defensive to offensive securities in falling and
6 Scudder, Stevens & Clark, Survey of University and College Endowment Funds
(New York, 1947).
7 John S. Bowen, "College Investments," Barron's, June 25, 1951, p. 5.
8 See footnotes 6 and 7, Supra.
161
rising markets. Considerable success is claimed for some of these
plans.9
6. Life Insurance Company Investments
Scope of the industry. The most important single type of savings
institution is the life insurance company. At the end of 1950,
there were approximately 600 domestic legal-reserve life insurance
companies, with combined assets of $64 billions. Among these
companies there were 13, each with resources of $1 billion or
more, that operated on a national basis and together accounted
for nearly three-quarters of the industry's total resources. Ninety
per cent of the industry's assets were owned by 49 companies.
The growth of the life insurance company group is indicated by
the following figures as of the end of selected years (dollar figures
in billions): 10
SELECTED DATA ON LIFE INSURANCE COMPANIES
Year
Total
Assets
Policy
Reserves
Total
Income
Insurance
in Force
1900
$ 1,742
$ 1,443
$ 8,562
1910
3,876
3,226
16,404
1920
7,320
6,338
$ 1,764
42,281
1930
18,880
16,231
4,594
107,948
1940
30,802
27,238
5,658
117,794
1950
63,984
54,927
11,250
241,981
* Not available.
Source: Institute of Life Insurance, Fact Book (annual).
The importance of life insurance companies as investors is also
indicated by the fact that at the end of 1950 they owned 7 per
cent of the Federal debt, 8 per cent of state and municipal bonds,
more than one-third of all of the funded debt of Class I railroads,
something more than one-half of the debt of the public utility
industry, and large proportions of the debt of many industrial
groups and of mortgages. They are currently growing at the rate
of over $4 billions per year.
See Lucile Tomlinson, Successful Investing Formulas (Boston: Barron's Pub-
lishing Company, Inc., 1947).
10 Sources: Institute of Life Insurance, Life Insurance Fact Book; The Spectator
162
As of 1950, about 90 per cent of the assets of life insurance com-
panies were owned by mutual companies, that is, companies
owned by the policyholders and managed by directors elected by
them. The balance is owned by stock companies operated for their
owners like any other corporation. Most of the insurance sold by
mutuals is of the participating type in which the policyholders
share in the net earnings of the company through participation
"dividends."
Sources of funds for investment. The funds to be invested by
life insurance companies are derived from premium payments.
Their continual great growth reflects continuous sales of new in-
surance and, in addition, the accretion of funds from level-pre-
mium receipts and from interest earnings on those funds. As
indicated in Chapter 4, most life insurance policies require an
annual premium that is more than sufficient in the earlier years
to meet death losses, and the excess is held in the form of a policy
reserve to cover claims in later years when the annual premium
is insufficient. The company accumulates this reserve at a rate of
interest guaranteed in advance and specified in the insurance
contract. The problem of investment is to earn this rate and at
the same time maintain sufficient liquidity to meet death claims
and withdrawal or borrowing of the reserve. If the actual rate
earned falls below the assumed or guaranteed rate, the company
must make up the difference by savings in operating costs or
mortality experience, or else increase its premium rates on new
contracts. If the premium payments plus the income on invest-
ments exceeds death claims and expenses and the necessary addi-
tions to reserves, a surplus arises which may be distributed to the
holders of participating policies or to the stockholders, in the case
of stock companies.
The nature of the life insurance business permits the establish-
ment of a conservative yet somewhat flexible investment policy.
In the first place, the liabilities of a life insurance company are
essentially long-term obligations, thus permitting investment in
longer-term, less marketable issues which offer the more attractive
rates of return. In the second place, revenue is constantly being
received in the form of premium payments based on actuarial
calculations, income from investments, and redemption of securi-
ties in such volume as to keep a degree of liquidity adequate for
163
death claims and for such emergency needs as might arise out of a
sudden demand for policy loans. In the third place, the premium
rates charged to policyholders assume a moderate rate of return
on investments, thereby eliminating any necessity of obtaining
yields higher than those provided by high-grade securities. And
last, but not least, the life insurance companies can afford invest-
ment departments qualified to make an intelligent analysis of
available securities and to maintain the most careful supervision
of securities owned.
The principles which underlie the investment policy of life in-
surance companies were concisely stated in an address of the
president of one of the largest companies:
1. The tradition of priority of liens, supported by reasonable
earnings, strong ownership, and ample equities.
2. The tradition of invariable amortization of mortgage loans,
correcting changes or overestimates in market value.
3. The tradition of diversification of investments, as to general
character, location, and number.
4. The tradition of constant analysis and criticism of holdings.
5. The tradition of moderation as to income yield being an ac-
curate yardstick of quality.
6. The tradition of honest charge-offs at frequent intervals, cor-
recting errors of judgment.11
Since the obligations of the life insurance company are ex-
pressed in terms of a definite number of dollars, there is no neces-
sity of providing for a hedge against inflation. Safety of principal,
adequate yield, and moderate liquidity are the keynotes of in-
vestment policy.
Investment restrictions. The high degree of public interest with
which life insurance companies are vested, arising from their
commitments to millions of policyholders and their role as savings
institutions, requires strict regulation of their operations in gen-
eral and of their investment policies in particular. Life insurance
companies operate under state charters and are subject to regula-
tion by the insurance commissioners of the various states in which
they do business. In addition, the character of their investments
11 From Investment Trends and Traditions, by William A. Law, an address be-
fore the Association of Life Insurance Presidents, December 10, 1931.
is set forth by state statute. Those companies that operate on a
national scale must comply with the investment laws in their sev-
eral home states and, to some extent, in the other states in which
they operate. Thus, the requirements of the most stringent of
these states determines the level of investment quality for the
particular company. The degree of state regulation and super-
vision varies considerably, but the general pattern runs as follows:
(1) Federal, state, and local government obligations are approved
without limit as to the proportion of total assets that may be so
invested; (2) corporate bonds, debentures, and direct business
loans are restricted to the higher-grade issueslimitations are im-
posed with respect to the percentage of total assets so invested,
as well as requirements for adequate earnings in relation to fixed
charges; (3) real estate first mortgages are generally approved,
subject to certain limitations on the amount lent in relation to the
value of the real estate mortgaged (often a two-thirds limit); (4)
common and preferred stocks are prohibited in one-third of the
states, and where permitted, they are restricted to a small per-
centage of total assets and strict asset and earnings standards are
required; (5) investment in real estate, other than company-used
property, is generally restricted, although in recent years most
states have permitted investment in rental housing and redevelop-
ment projects and certain types of commercial and industrial prop-
erty up to a modest percentage of total assets; (6) loans to
policyholders equal to the reserve value of their respective policies
are authorized in every jurisdiction.
Companies with home offices in New York State do about 40
per cent of the life insurance business, and the New York laws
have been used as models tjy a number of other states. Two gen-
eral sets of investment regulations apply in the state: (1) those
governing the investment of minimum capital which are required
for domiciled companies and the securities that must be deposited
by foreign companies admitted to do business within the state;
and (2) those governing the bulk of the funds, namely, policy
reserves plus any balance over minimum capital requirements and
surplus. The first group may include only Federal obligations,
New York State and municipal obligations, obligations of other
states, and mortgage loans. The second group includes the first-
mentioned types plus the following:
165
1. Collateral trust bonds on which the interest has been earned
at least 1% times during each of any three years, including the last
two years, of the last five years.
2. Unsecured bonds on which the fixed charges have been
earned at least 1& times during the last five years, including the
last year.
3. Contingent interest bonds, where the average annual fixed
and minimum contingent interest has been earned at least l)2
times during the last five years, including the last two years.
4. Preferred and guaranteed stocks, where fixed interest, con-
tingent interest, and dividends have met the standards set forth
in #3 above. Such investments are limited to 10 per cent of the
stock of the issuer and 2 per cent of the admitted assets of the
insurance company.
5. Trustees' and receivers' certificates.
6. Equipment trust certificates.
7. Bankers' acceptances and bills of exchange.
8. First mortgage bonds and loans on unencumbered real prop-
erty located in the United States not exceeding two-thirds of the
value of the property except on guaranteed loans to veterans.
Mortgage loans on any one property are limited to $25,000 or 2
per cent of admitted assets, whichever is the greater. The maxi-
mum investment in all mortgage loans is 40 per cent of admitted
assets (exclusive of FHA and veterans' loans).
9. Purchase money mortgages.
10. FHA-insured and VA-guaranteed mortgages.
11. First-lien bonds and mortgages secured by New York hous-
ing projects in New York State guaranteed to at least 40 per cent
under Title III of the Servicemen's Readjustment Act of 1944.
12. Income-producing real estate, other than that used for the
conduct of business or acquired in satisfaction of loans, not in
excess of 3 per cent of admitted assets.
13. Housing projects, not to exceed 10 per cent of admitted
assets.
14. Canadian government bonds up to 10 per cent of total ad-
mitted assets.
15. Stock or debentures of any housing company organized
under the public housing law of the state.
16. Stock of a Federal Home Loan Bank.
17. Obligations of the International Bank for Reconstruction
and Development not in excess of 5 per cent of total admitted
assets.
18. Policy loans.
19. Common stocks, up to 3 per cent of admitted assets or one-
third of surplus, whichever is the smaller.
Newer forms of investments. Provisions such as the foregoing
would appear to give life insurance companies sufficient flexibility
and scope in their investment policy without any need for depart-
ing from the traditional forms of securities and other investment
media. But in recent years the earning rate produced on invest-
ments has tended to decline, following closely the interest rates
on United States Government securities and high-grade corporate
bonds. The net rate of return earned by United States life insur-
ance investments on their aggregate mean ledger assets in 1930
and from 1940 to 1950 has been: 12
1930 5.05% 1945 3.07%
1940 3.45 1946 2.92
1941 3.41 1947 2.88
1942 3.40 1948 2.96
1943 3.29 1949 3.04
1944 3.19 1950 3.09
Such rates are in sharp contrast to the average for the 1930's (4.10
per cent). Two courses of action have been taken to offset the de-
clining rates of earnings: (1) most companies have reduced the
interest rate guaranteed in new policies, in some cases to as low
as 2 per cent; (2) new forms of investment have been developed
within the framework of the law in an effort to increase average
earnings.
One of the most interesting departures from tradition has been
the development of term loans to business. Insurance companies
are now active competitors of commercial banks in this respect.
Another departure has been the "private placement" by which a
corporate issuer negotiates directly with the insurance company
for the sale of an issue of securities. At first sight this may not seem
very different from the purchase of bonds in the market; the sig-
nificance to the insurance company is that it is responsible for
seeing that adequate provisions are included in the indenture of
12 Source: Institute of Life Insurance, Life Insurance Fact Book.
167
the bond issue for its own protection, since such an issue does not
go through the hands of an investment banker.
Another development has been the emphasis, within the legal
limits, on the purchase of real estate for income and on the con-
struction of housing and business property. Of particular interest
is the sale-lease arrangement by which the insurance company
acquires or constructs improvements that are leased back to the
business user. The net return on such investments may run as high
as 4 per cent.
A fourth development has been the growing pressure for re-
laxation of state laws to permit the purchase of common stocks.
As indicated previously, about two-thirds of the states now per-
mit the purchase of common stock by life insurance companies,
up to a small percentage of total assets. The lack of a wide selec-
tion of high-grade bonds and the low yields on such securities
have encouraged the movement toward equities. And even in
those states, such as New York and Pennsylvania, where common
stock purchase is permitted, management has been reluctant to
change from its conservative attitude to take the greater risks that
would be involved in such equities.
In the spring of 1951, the New York State insurance law was
amended to permit insurance companies domiciled in that state to
make limited investments in common stocks. Through this amend-
ment New York companies are allowed common stock investments
up to 3 per cent of admitted assets, or one-third of surplus, which-
ever is the smaller. Since surplus is usually less than 3 per cent of
assets, the legal limit is provided for most companies. Holdings of
the common stock of any one corporation are limited to one-tenth
of one per cent of the life insurance company's assets and to 2 per
cent of the issuing corporation's outstanding stock. To be eligible
for insurance company investment, the stock must meet the fol-
lowing requirements: (1) the stock must be listed on an exchange
registered with the Securities and Exchange Commission; (2)
dividends must have been paid for ten years prior to acquisition
date, and the company must have earned during such period an
average annual rate of 4 per cent of par or of the issue price;
(3) all of the bonds and preferred stock, if any, of the issuer must
be eligible for insurance company investment; (4) purchase of
insurance and bank stocks is not permitted.
168
This change in the New York law opens up a large potential
market for qualified securities by opening up a new field for New
York companies and for out-of-state companies doing business in
New York. However, the increase in common stock investments
over the figure shown later in this chapter is likely to be slow,
since many companies are either unwilling or unprepared to ex-
pand into the common stock field.
Much of the appeal of common stocks grows out of the need
for a higher rate of return, as indicated above. But an even greater
problem is the need for adequate outlets for the vast sums being
accumulated by the insurance companies. Each year, between
$3/2 billions and $4 billions of new money needs to be invested,
together with possibly $2 billions of funds from maturing assets.
What shall be done with this money? High-grade corporate bonds,
although appropriate in character, yield a return only slightly
above that on Federal obligations, and a substantial change in in-
terest rates could so lower their value as to impair seriously the
surplus reserves of the companies. There are not enough of these
obligations, together with mortgages, to soak up the insurance
funds seeking investment. Loans to business and investment in
housing projects and commercial income-producing real estate
offer possibilities, but these are limited and the managerial costs
are high. The vast supply of common stocks would appear to offer
intriguing possibilities for insurance investment. Wise selection
and adequate diversification in sound companies would produce a
generous return and enable the companies to build up their re-
serves.
Against this point of view are the arguments that: (1) the
amount and timing of dividends are uncertain, whereas the com-
panies must accumulate their policy reserves on the assumption
of a "guaranteed" rate of interest; (2) common stocks are subject
to wide price swings that would impair the reserves of the com-
panies in depressed markets; (3) even the supply of sound com-
mon stocks is inadequate in relation to the rate at which insurance
company assets are growing. Such arguments will probably con-
tinue to dominate the thinking of the public, the insurance com-
pany managements, and the legislatures, and will restrict the
investment in common stocks at the expense of lower earnings
and higher premiums on policies.
169
Investment policy. An examination of the investment holdings
of American life insurance companies indicates some significant
changes in investment policy. The following table shows the per-
centage breakdown of the assets of United States legal-reserve
companies at the end of 1930, 1940, and 1950 (amounts in billions
of dollars): 13
19S0
J 940
1950
Bonds:
Amt.
Per Cent
Amt.
Per Cent
Amt.
Per Cent
U. S. Government
$ .3
1.82
$ 5.9
19.0%
$13.4
21.02
State and municipal
1.0
5.4
2.4
7.7
1.6
2.4
.1
.6
.1
.4
1.1
1.7
2.9
15.4
2.8
9.2
3.2
5.0
Utility
1.6
8.6
4.3
13.8
10.6
16.5
Industrial and misc.
.4
1.9
1.5
5.0
9.5
14.9
Mortgages:
$ 6.3
33.7
$17.0
55.1
$39.4
61.5
2.1
10.9
.9
2.9
1.3
170
middle twenties they amounted to one-fifth of total assets. The
depression of the thirties, with its disastrous effects on the railroad
industry, together with the growth of new industries in recent
years, caused a diversion of funds into utility and industrial bonds.
As the table above reveals, investments in the two latter groups
now greatly exceeds investments in rails. The increase in utility
holdings to 16.5 per cent of total assets reflects the important part
that the insurance companies have played in the growth of that in-
dustry. Growth of industrial holdings has been spectacular in the
past two decades, reflecting the changes in the legal restrictions,
the search for new investments, and the rise in the investment
status of the stronger industrial corporations.
Real estate mortgages have always formed a significant segment
of life insurance company investments, but their relative impor-
tance has changed greatly over the years. The experience in the
depression years of the 1930's and the lack of marketability of
mortgages, together with the appeal of corporate bonds, has re-
sulted in a shift that has reduced mortgages from the most im-
portant single type of investment to one of only substantial pro-
portions. The low point was reached in 1946, when this type
accounted for less than 15 per cent of total assets. Since that year,
FHA, VA, and other mortgages on domestic and commercial
properties have increased substantially, bringing the 1950 figure
to $16.5 billions, or 25.2 per cent of total assetsabout the same
proportion as in 1934.14
Policy loans reach their highest levels during depressions, when
they serve a useful purpose in helping to tide policyholders over
periods of stress. They reached a peak of $3.8 billions, or 18.3 per
cent of total assets, at the end of 1932, and reached their lowest
point of $1.9 billions in 1946. That they do not vanish entirely in
good times is indicated by the $2.4 billions outstanding at the end
of 1950.
Study of investment figures over the years shows a constantly
changing pattern. It is likely that the relative importance of gov-
ernment holdings will continue to decrease and that non-housing
real estate, rental housing, industrial securities, and possibly stocks
will show important increases over the next decade.
14 See Chapter 30 for additional discussion of mortgage loans by insurance
companies.
CHAPTER 11
INDIVIDUAL INVESTORS
Scope. The purpose of this chapter is to apply the material in
earlier chapters concerning investment media and investment
principles to the problems of investment by individuals. The order
of discussion is: (1) review of investment media, (2) factors mak-
ing for individual differences, (3) application of investment
principles, (4) investments of the young family, (5) the estab-
lished professional man, (6) the established business man, (7)
the widow or retired couple, (8) the wealthy investor.
Review of investment media. Chapters 2 to 6 inclusive were
concerned with a description of the various media of investments.
Emphasis was placed on savings institutions and corporate se-
curities. Three major types of media were omitted from the dis-
cussion: (1) government securities, both foreign and domestic
(other than United States Savings Bonds); (2) shares in financial
companies and investment companies; and (3) real estate and real
estate securities. It is felt that the general description of these
types should be combined with the techniques of analysis that may
be applied to them, as set forth in the later chapters devoted to
these groups.
One conclusion that may be drawn from the description of in-
vestment media is that there is available a surprising variety of
types. No one type or group is likely to suit the needs and purposes
of the investor, but various combinations are available that may
satisfy his requirements. The investor owes it to himself to be
acquainted with all possibilities. A second conclusion is that, with
a few notable exceptions, such as insured bank accounts and
Federal obligations, it is difficult if not impossible to generalize
about the investment merits of any class of media, because of the
range of quality within each class. The investor's problem is ob-
viously not solved unless he is able to choose discriminately within
171
172
the group or type that in general seems most feasible for his pro-
gram.
Factors making for individual differences. Individuals and their
needs are affected by such a wide variety of factors that it is im-
possible to generalize concerning their investment objectives or
the means by which these objectives are to be accomplished.
Variations occur with respect to such matters as amount of funds
available for investment, the size of the total resources of the in-
vesting individual or unit, his or their age, health, training, tem-
perament, and ability to manage their own affairs, the number of
dependents to be cared for, the amount of time and attention that
can be devoted to financial affairs, social and personal ambitions,
and many others. All of these will cause each investor's problem
to be somewhat different from that of all other investors, in small
or in large degree. However, in spite of the fact that these differ-
ences do exist, an approach may be made toward itemizing com-
monly found investment objectives and the principles that should
govern investment for the attainment of these goals.
Application of investment principles. The following discussion
is based on certain common investment objectives and the applica-
tion to these aims of the general principles of investment manage-
ment discussed in previous chapters. The order of priority and the
portion of the savings to be devoted to each objective will, of
course, vary from case to case. Obviously, the size of the funds
that can be devoted to investment restricts or widens the objec-
tives that can reasonably be attained. In budgets allowing for very
modest savings, the only objectives that can be obtained are those
at the top of the suggested list. As annual savings increase or are
accumulated, the objectives can be widened and more risk can be
taken. And the objectives themselves will change through the
years with the changing circumstances of the investing individual
or family.
1. Emergency funds. A reserve of from three to six months'
income to take care of any number of sudden hazards or drains
that confront most investors is high on the priority list. Together
with life insurance, it enjoys first place in most programs. The
possibility of sudden stoppage of income (other than through the
death of the income-producer), sudden expenditures not provided
for by casualty and property insurance, unexpected personal ex-
173
penses, and many other items suggest that some portion of savings
be maintained in cash or in otherwise highly liquid form. The
inherent conservativeness of the investor will also affect his feel-
ing concerning the need for eminently liquid resources available
on very short notice.
The sole requirement for emergency funds is recovery of dollars
when needed, and only very modest income can be expected from
this portion of the fund. It is held in the form of bank demand or
savings deposits. Accounts in savings and loan associations, Sav-
ings Bonds, and other liquid sources may also be considered for
this emergency fund, but they produce at least modest income
and are suitable for more then emergency purposes. The cash-
surrender value of life insurance policies should never be relied on
as a regular segment of the emergency cash fund; it may have to
be withdrawn or borrowed in case of dire need, but when this is
done the continuation of the protection it is designed to give is
threatened.
The investment attributes of the cash reserve are summarized
as: complete liquidity, little or no income, freedom from care,
satisfactory denomination. Tax status is not considered, and, of
course, no inflation hedge is provided.
2. Protection against death of the income-producer. For the
vast majority of investors, the untimely death of the income-pro-
ducer constitutes a threat that can be offset only by the provision
of adequate insurance. Adequate insurance provides an estate that
would be difficult for most investors to provide through any other
means.
The general investment attributes of life insurance and the main
types of policies have been discussed earlier (Chapter 4). The
amount of insurance protection that is needed depends on a num-
ber of circumstances that vary from case to case: the number and
age of. dependents, the funds available for premiums at the age
of the insured, the living standards desired-for dependents, and
the size of the estate exclusive of the insurance element. An in-
surance plan providing for maximum protection when most
needed and retirement income when the need of death benefits
has been reduced can be worked out for each individual family
situation.
The investment requirements fulfilled by insurance are: liquid-
174
ity (in the event of death); modest income for the beneficiaries
through any one of several methods of distributing the face of the
policy, and possible retirement income for the assured; complete
freedom from care and management; satisfactory denomination
and diversification; favorable tax status (insofar as proceeds are
concerned). No protection is provided against rising prices, be-
cause the obligation of the insurance company is to pay a con-
tractual dollar sum. One of the defects of insurance is that it
promises to pay in terms of dollars rather than in purchasing
power. The insured has no choice but to increase his insurance
protection against the prospect of cheapened dollars at the time
of death or retirement. Some would argue that if the life insurance
company were permitted to invest heavily in common stocks, the
higher return obtained would permit lower premiums (more in-
surance) and more generous "dividends" or rebates that would
help to offset a rising price level. To obtain such results at the
expense of safety would, of course, threaten the basic purpose of
insurance protection. It would be a sounder policy for the insured
to supplement his insurance estate by his own purchase of equities
if he can assume the risks that such commitments involve.
Over and above minimum insurance protection (to insure a
reasonable standard of living for dependents), funds accumulated
for the support of dependents in the event of death of the insured
can be invested in a variety of forms, depending on the risks that
can be assumed. A wide range from income-producing high-grade
bonds to common stocks can be utilized. And such factors as the
degree of management required, tax status, and hedging will bulk
large or small depending on the individual circumstances. For
wealthy investors, estate and inheritance tax considerations would
be a major consideration.
Since the aim of protection of dependents is high on the list of
priorities, the vast majority of investors should build this portion
of the fund at a minimum of risk, through the use of insurance,
even in the face of continued decline in the purchasing power of
the fund. Regardless of how astute the investor may think he is
in the management of funds, to rely on market appreciation of
securities to provide the minimum essentials of life for dependents
is to flirt with disaster.
3. Home ownership. The purchase of a home for occupancy is
175
probably the largest single investment ever made by the majority
of families. The financial aspects of the commitment are discussed
elsewhere (Chapter 30). At this point it is only necessary to sug-
gest that the funds accumulated for eventual home ownership
should be relatively risk-free. The investment requirements are
recovery of principal, possibly modest income from the fund until
the home is acquired, considerable if not total freedom from care,
and diversification until the home is acquired. If the time of pur-
chase is considerably in the future, and if the family can afford
the risk of equities, the growth of a fund invested in stocks, di-
rectly or indirectly, may possibly offset the rising costs of real
estate. But again there would be relatively few investors who
could hazard the sum being accumulated for such an important
purpose. And the time of the purchase might coincide with de-
pressed stock prices.
The modern method of amortizing the purchase of a home
through a long-term mortgage solves many of the problems in
investing for this purpose and relieves the home-buyer of the
responsibilities of management of the funds in the meantime. The
sum required to meet the payments of interest plus principal is a
budget item that ranks in importance only second to food and
clothing. The hazard of loss of savings being held by the investor
himself against eventual purchase of property is eliminated, at
least as long as he is able to meet the terms of the loan and to avoid
jeopardizing his growing equity in the property by default.
Once a substantial equity has been acquired, the investor has a
considerable sum tied up in fixed property. The portion of his sav-
ings so invested is subject to the risks of changing land values,
obsolescence, neighborhood decline, and the accentuated swings
in the real estate market. The denomination is large and diversifi-
cation is sacrificed. To offset these perils, the owner of well-
selected, well-maintained property may derive a considerable in-
direct income from this part of his funds (depending on going
rentals for alternative rented property) and may enjoy a valuable
hedge against the decline in the buying power of the dollar. The
ownership of such property provides the only substantial oppor-
tunity for hedging that many investors are in a position to enjoy.1
1 The investment aspects of home ownership are discussed further in Chapter 30.
176
4. Education and other family needs. A variety of objectives
of a specialized character are found in every family's investment
planning. Among these the education of children frequently plays
a prominent part. Funds saved for such a purpose must be sub-
stantially risk-free. They should be invested so as to accumulate
a certain definite sum at the time of need. For such a purpose a
regular program of investment in Savings Bonds is almost ideal.
These can be bought in large or small denominations to mature
during the period when the funds are needed, and, if the plan is
begun early enough, the compounding of the 2.9 per cent yield
to maturity will add considerably to the size of the fund. It is
suggested that a certain portion of the life insurance program be
earmarked for education and similar vital purposes so that these
goals may be fulfilled whether the head of the family survives or
not.
5. Retirement income. In many cases the next objective in the
order of investment thinking is the provision of income at retire-
ment age. The importance of this goal will, like the others pre-
viously discussed, vary from case to case. For young families this
objective will be given little attention during the early years when
more significant needs are more pressing. But with the passage of
the years, the need for taking care of retirement begins to loom
large. Some investors will rely substantially on Federal Old Age
and Survivorship Insurance (Social Security) benefits, other pub-
lic retirement arrangements, or on private pension plans. Others
will be in a position to supplement these plans with accumulations
under their own control.
For investors to whom a minimum of risk and complete freedom
of management is important, the annuity is indicated as likely to
produce the best long-run results. Modern annuity contracts are
being written at very modest "guaranteed" rates of accumulation
some as low as 2 per centand this in the face of a secular
rise in the cost of living. This combination of circumstances means
that a much larger outlay for annuity protection is required to
produce the same real income at retirement. Nevertheless, the
investor who is in no position to assume risk or to assume the
responsibilities of managing an investment fund must continue to
rely heavily on the annuity for an assured stipend in later years.
Other investors may point toward retirement through a long-
177
range program of security purchases, either through a balanced
fund of bonds and stocks or through the regular purchase (pos-
sibly dollar averaging) of carefully selected investment company
shares. Such investors must be prepared to see the value of such a
fund rise and fall with the course of the security markets, but over
the long run the results may very well produce an accumulation
that will be considerably in excess of the value of an annuity.
This is especially the case if current income can be reinvested so
as to compound the results over a considerable period of time.
Those investors who have sufficient time and skill to manage their
own funds may emphasize the direct purchase of sound-growth
stocks; others would be well advised to rely on a program of sav-
ing through Savings Bonds and on the growth of a fund invested
in the shares of investment and insurance companies which have
demonstrated an ability to produce a better-than-average record.
The proportions of the retirement fund that will be devoted to
bonds and to equities will, of course, depend on the size of the
fund and the investment skill and knowledge of the investor.
Similarly, the character of the fund will also be influenced by the
relative importance of suitable denomination, tax status, and the
need for, offsetting the declining value of the dollar.
6. Supplementary income before retirement. When the primary
objectives outlined above have been fulfilled or funds set aside
for their eventual fulfillment, the remainder of the investment
program may involve more risk-taking. Recovery of principal may
be given less importance and current income may be stressed.
Investors who have achieved the early and important goals may
consider a balanced fund of bonds and stocks (or other equities)
as a means of supplementing their regular income, and in the
selection of these securities they may use the sources of informa-
tion and analvtical methods described elsewhere in this volume.
The need for a "second income" derived from investments
grows as the price-level rises. Such an income can be obtained in
a haphazard fashion by the occasional purchase, at opportune
times, of income-producing securities Here the investor faces the
problems of selection, valuation, and timing that require con-
siderable skill and experience. He must make the decision either
to direct his own investment buying and selling, with the aid of
services and other sources of advice and information, or to turn
178
his affairs over to others. Even if the latter decision is made, it is
important that the investor be well acquainted with investment
principles so that he can understand and review the decisions
made on his behalf. Relatively few investors can afford to turn
their affairs over to others without any review or check on their
part.
The type of investments to be made for supplementary income
will vary with the individual case. Where modest but secure in-
come is the goal, a balanced fund consisting of good bonds and
stocks with unusual dividend records is indicated. Complete free-
dom from management can be obtained through the establishment
of a living trust fund or the purchase of an immediate annuity.
The business or professional man may take advantage of the higher
average yields on common stocks by the acquisition of a diver-
sified list of such securities, or by the purchase of fire insurance
company shares, or shares of investment companies that invest
primarily for income rather than appreciation. The wealthy in-
vestor may take advantage of the tax-exemption feature of state
and municipal bonds for a substantial section of his fund, the
balance to be invested in higher-risk equities. Such an investor is,
of course, likely to place more importance on preservation of
capital and on estate planning than on current income.
7. Creation of an estate. The final goal of some investors, after
providing for the above requirements, is the creation of an estate
for dependents (over and above minimum insurance require-
ments), charities, and other beneficiaries. Estate planning is a
complex problem involving income and estate tax considerations,
drafting of an adequate will, selection of executors and trustees,
gift planning, insurance, and general investment policies. The in-
vestor fortunate enough to have provided for the more important
needs is in a position to retain the services of firms making a
specialty of estate planning. Such firms employ or retain attorneys,
tax experts, insurance advisers, and investment counsel. The in-
vestor should, however, be well acquainted himself with every-
thing that is done for him.
The general investment requirements in planning for a sub-
stantial eventual estate are: (1) tax relief on current income; (2)
a substantial degree of liquidity for estate and inheritance tax
purposes, through either insurance or a liquid segment of the
179
investment portfolio; (3) minimizing the estate and inheritance
tax burden; (4) the growth of the fund over the years by com-
pounding the returns derived from portfolio; and (5) the pro-
vision against dissipation of the value of the fund in terms of
dollars and of purchasing power. Practically all of the media of
investment described previously might be involved in such a pro-
gram, the amounts and proportions of each being determined by
the individual circumstances.
Illustrative situations: 1. Investments of the young family. The
young family consisting, say, of husband, wife, and two small
children, with an annual income of $5,000 before taxes, is likely
to be unable to do more than make a start on the more funda-
mental investment objectives outlined previously. Under present-
day conditions provision for an emergency fund, a modest amount
of low-cost insurance, and payments on a home are likely to absorb
all available savings. Funds for education and other family needs
may be accumulated through the purchase of Savings Bonds as
the income increases, and a start toward retirement income may
be provided through Social Security payments. For the majority
of young families, investment for appreciation, although desirable
in a period of rising prices, cannot be considered; hence the pur-
chase of equities (other than the growing stake in a home property
or in a business) is out of the question. For some years it is likely
that deposit-type investments, United States Savings Bonds, and
other safe and liquid but low-income sources will dominate the
program. Only when first things have been taken care of will the
risks of common stocks be undertaken, and even then many young
families would be advised to turn to shares in investment com-
panies and fire insurance companies for the diversification and
professional management that the busy young business or pro-
fessional man is unlikely to be able to provide himself.
2. The established professional man. The professional man well
launched on a prosperous career is likely to have made provision
for the prime essentials that stand at the top of the list of invest-
ment priorities and is in a position to assume considerable risk,
depending, of course, on his individual circumstances. Such an
investor would put major emphasis on (1) additional current in-
come, (2) provision for eventual retirement, and (3) the creation
of a fairly substantial estate over and above that provided by in-
180
surance. Investing for capital appreciation is involved in the last
two of these goals. His investment program should include a fund
of seasoned bonds and preferreds to provide a backlog of less
volatile securities, and a steady accumulation of common stocks
over the years, preferably through the use of the dollar averaging
technique. If his fund is very substantial, he can afford to employ
the services of an investment counsel; otherwise, he would do well
to consider investing in the shares of carefully selected invest-
ment companies. His absorption in professional activities is likely
to leave little time and provide little opportunity for training
in security analysis and the management of his own funds. He may
be a shrewd direct investor; but he is ordinarily out of touch with
business and financial affairs and is likely to be tempted to make
sudden and possibly unadvised investment decisions.
Depending on the size of the accumulated fund and the annual
savings available for investment, on the age and health of the in-
vestor, the number of dependents, and numerous other considera-
tions, the degree of risk that can be undertaken will vary greatly
^ from case to case. Possibly in the majority of cases the professional
man had better lean to the conservative side lest his time and
attention be diverted from his main line of activities. However,
he can commit a substantial portion of his savings toward retire-
ment to growth and inflation-protection stocks or to shares of
investment companies that emphasize these qualities. His need
for substantial current-dividend income will depend on the
amount and stability of his professional income; in recent years,
and for the foreseeable future, his costs will have been rising, and
he may wish to select stocks with substantial dividends which at
the same time offer good long-range appreciation possibilities.
Depending on the tax bracket in which any new income would
fall, this investor may be more or less interested in including tax-
exempt municipals in that portion of his retirement fund devoted
to high-grade securities.
3. The established business man. The frequently used expres-
sion "business man's risk" or "business man's investment" implies
two things: (1) that this type of person is in a position to assume
considerable risk, and (2) that his business training and experience
fit him to keep a close eye on economic and financial conditions
and to exercise unusual acumen in the selection and manage-
181
ment of securities. These qualities may or may not exist. Further-
more, his preoccupation with his own affairs may not provide the
necessary time for adequate investment management; on the other
hand, he may be in very close contact with and be able to inter-
pret and use sources of investment information that will produce
better-than-average results.
If our successful business man is in no need of large current
income from his portfolio, and if he is in the upper tax brackets,
he is likely to pay particular attention to the production of long-
term capital gains. He is also likely to be particularly interested
in short-run or speculative activity and in the search for invest-
ment bargains.
Possibly this type of investor can devote a substantial portion
of his stock fund to securities whose appeal is temporary, as in
the case of war beneficiaries; the balance of his fund of equities
should be devoted to stocks selected for their long-run or true
investment merits. An honest appraisal of his past experience will
suggest his real ability to make sound decisions concerning the
selection and timing of purchases and sales; a disappointing record
in this respect would suggest that at least a portion of his "aggres-
sive" portfolio should be placed in the hands of others with more
experience and more facilities for accurate appraisal of the market
and of individual securities.
The "business man type" includes such a wide variety of in-
vestment situations as to make dangerous any generalizations
concerning this type's ability to assume risk, to gauge market
trends, or to select and manage a securities portfolio. Tax con-
siderations will vary in importance from case to case. The need for
liquidity will also vary, depending especially on the type of busi-
ness in which he is engaged and whether his own business is stable
or uncertain. If a substantial portion of his savings are tied up in
his own enterprise at considerable risk, his outside or investment
portfolio should, like that of the professional man, lean toward the
conservative.
4. The widow or retired couple. A growing number of persons,
both in absolute terms and as a percentage of the total population,
are dependent upon a fixed dollar income after the working years
have passed. The extension of Social Security benefits to an en-
larged list of the elderly, plus the increase in the dollar amount
182
of these benefits, has made a very substantial provision against
actual want after retirement. But the maximum Old-Age and Sur-
vivorship Insurance (OASI) retirement income for a single man
or woman is $960 a year and for an aged couple $1,440, with pay-
ments ranging all the way down to the minimum of $240 and $360
per year, respectively (as of 1950 legislation). While such pay-
ments are of great value, they fall below the minimum subsistence
level, and many important groups are not yet covered by the plan.
To supplement these benefits, and to be independent of relatives
and local charity, retired persons need a supplemental income
derived from investments.
It is assumed for purposes of this discussion that the retired in-
vestors we have in mind have no longer any need to provide for
dependents and that other objectives, such as home ownership,
have been reached. Therefore, the main problem is the main-
tenance of an income for their own needs. There was a time when
the sum of $100,000, or even $50,000, invested in high-grade
securities could provide for reasonable living standards. Just prior
to World War I, for example, an investment of $100,000 in high-
grade bonds provided $5,000 tax-free income. After World War
II, allowing for the decline in interest rates (to 2%%), for income
taxes, and for the lowered buying power of the dollar (45% of
1913), it would take $500,000 to provide the same real income.2
Thus, a real dilemma is posed for the rentier classwhether to live
on secure income in sharply reduced circumstances, or to take
greater risk and magnify income through investment in equities,
or to consume principal.
The table opposite shows the pre-tax dollar return from a
$100,000 fund invested in various media, under conditions pre-
vailing in the middle of 1951.
The current low returns on high-grade investments, combined
with the high cost of living, make it virtually impossible for the
retired person to live on the income of what was once considered
a substantial capital sum. Thus, the temptation to magnify income
by turning to riskier commitments is very strong. Yet to the ma-
jority of retired investors, the avoidance of loss must be the major
consideration in investment policy. The dilemma involved in
2B. Graham, The Intelligent Investor (New York: Harper & Bros., 1949), p. 6.
183
YIELDS FROM SELECTED INVESTMENT MEDIA
Medium of
Representative
Dollar
Investment
Yield
Income
1.50%
$1,500
2.00
2,000
Savings and loan association account
2.50
2,500
U. S. Government Savings Bond Series G
2.50
2,500
2,680
2,980
3,550
3.81
3,810
6.45
6,450
* Moody's average of 7 bonds averaging 19 years, 10 months to maturity, as of July 2,
1951.
** Moody's Aaa composite as of July 2, 1951.
t Moody's Baa composite as of July. 2, 1951.
+Moody's high-grade industrials as of July 4, 1951.
*** Dow-Jones 30 industrials, as of July 13, 1951.
this choice between low income with low risk and higher income
with higher risk can best be solved by utilizing both income and
principal to maximize annual returns (1) through annuities estab-
lished as such or based on the proceeds of life insurance policies,
(2) through gradual liquidation of high-grade securities not sub-
ject to material market fluctuation, or (3) through the establish-
ment of a living trust providing for regular payments of interest
and principal. For the second of these methods, the regular liqui-
dation at maturity of a fund of United States Savings Bonds has
much merit.
5. The wealthy investor. The wealthy investor has several dis-
tinct advantages over most other types with respect to investment
policy: (1) he can afford the risks that higher-yielding equities
inevitably involve; (2) he can obtain ample diversification in his
own portfolio; (3) he can gain a very material advantage from the
tax-exemption feature of state and municipal bonds and should
substitute these for other high-grade corporate and Federal ob-
ligations in the bond section of his portfolio; (4) he can make
full use of the capital gains provisions of the Federal income tax
law; (5) he can afford to employ the services of competent invest-
ment counsel to "tailor" for him a program that will combine his
needs for income, capital appreciation, and estate tax protection;
(6) he can employ the formula planning device to avoid the
184
hazardous task of timing the swings in the securities market; and
(7) he can use some of his principal if he wishes to do so.
For such investors, matters of income and estate tax planning
bulk even larger than purely investment considerations. Apart
from a substantial fund in high-grade short-term securities held
for the purpose of meeting estate and inheritance taxes, together
with any specific investments that represent business commit-
ments, the wealthy investor's portfolio will consist substantially
of tax-exempts, a varying "defensive" balance in cash or high-
grade bonds, and common stocks. Whether he manages such a
portfolio himself, or utilizes the medium of the investment com-
pany, or employs professional investment management will de-
pend on his own investment competence and confidence and on
the complexities of the particular situation.
The wealthy investor can achieve a considerable degree of
freedom from care through the medium of a personal trust fund,
through holding investment company shares, or through the use
of counsel. However, he should always be in a position to review
and check the decisions of others.
PART IV
INVESTMENT MECHANICS
SOURCES OF
INFORMATION
(12)
INFORMATION
FINANCIAL
PAGE
(13)
INVESTMENT
BANKING
(14)
SECURITIES
MARKETS
(15)
MARKETS
SECURITIES
ORDERS
(16)
MATHEMATICS
(17)
YIELD
TAXATION
(18)
CHAPTER 12
SOURCES OF INVESTMENT
INFORMATION
Scope. The purpose of this chapter is to indicate the more im-
portant sources of information that help investors to keep informed
currently and to make intelligent investment decisions. The order
of discussion is: (1) daily business and financial periodicals, (2)
weekly business and financial periodicals, (3) monthly business
and financial periodicals, (4) quarterly investment and financial
periodicals, (5) banking periodicals, (6) general periodicals, (7)
information on governmental securities, (8) information on in-
dustries, (9) "information on companies and their securities, (10)
the statistical services, (11) information on special classes of se-
curities, (12) security market forecasts, (13) investment advice.
The tools of investment. Intelligent investment is to a consider-
able degree a matter of adequate knowledge. Although all in-
vestment commitments involve estimates of future developments
that can be foreseen only imperfectly, the greater the knowledge
the investor has of facts and of the degree of risk involved, the
more satisfactory his experience should be. The investor who
makes decisions without a careful study of the facts has only his
own carelessness or lethargy to blame for at least part of subse-
quent misfortune.
It has been said, "No lawyer knows the law, but a good lawyer
knows where it can be found." In similar fashion it might be
stated that, while no investor can keep fully informed, he should
know where to obtain information that will enable him to make
an intelligent investment decision. There is available to him a
growing fund of information in a wide variety of sources. Some
of these sources deal with the general business situation and out-
look; others provide material concerning specific industries, com-
panies, and securities. Some of the information is from primary
187
188 SOURCES OF INVESTMENT INFORMATION
sources; often it is offered in digested or semi-digested form in
secondary sources. So the investor is faced with a twofold prob-
lem (unless he turns his investment problems over to other man-
agers): (1) where to get the information; (2) how to sift and
weigh it to his advantage. The present chapter is concerned with
the first of these problems; much of the remainder of this book
is devoted to the second.
Daily business and financial papers. The least that any investor
can do is to follow current developments in the financial section
of his daily newspaper. But the information in such journals is
usually very sketchy. Daily business news and financial material
are better obtained from special daily business and financial
papers.
1. The Journal of Commerce (New York) emphasizes com-
modities and shipping and commercial news. But it has a good
financial section, and it has perhaps the best list of current quota-
tions of unlisted securities.
2. The Wall Street Journal is published by Dow Jones & Com-
pany in four editionsNew York, Chicago, San Francisco, and
Dallas. In addition to general business news, it emphasizes notes
on individual companies and industries and has a complete quo-
tation section. The Chicago, San Francisco, and Dallas editions
emphasize, respectively, middle-western, western, and south-
western industries and companies.
Weekly business and financial periodicals. In addition to one
of the dailies mentioned above, the investor should have access to
general business and financial references that cover a wider scope
than daily events. The following are representative.
1. Barron's, published in Boston, is a very readable source on
business trends, industries, companies, and securities. Short anal-
yses of individual situations are emphasized. The central section,
"The Stock Market at a Glance," provides a most convenient
compendium of security prices, earnings, and dividends, covering
unlisted securities and investment funds as well as stocks listed
on the New York and Curb Exchanges.
2. The Bond Buyer (New York) is devoted entirely to daily
(and weekly) news concerning Federal, state, and municipal
securities. An annual volume is also published under the title
Municipal Bond Sales.
SOURCES OF INVESTMENT INFORMATION 189
3. Business Week covers the general business field and has an
interesting section devoted to financial developments.
4. The Commercial and Financial Chronicle is the most com-
prehensive financial publication. The Monday issue (Section I)
contains corporate notes and complete quotations on all ex-
changes. Over-the-counter quotations on non-industrial securities
are included. Section II (Thursday) contains contributed articles
and discussions of the weekly developments in the financial, bank-
ing, industrial, and commodities fields. Coverage is encyclopedic.
This publication is "the bible" of Wall Street, but its 100 weekly
pages of investment, financial, and economic articles and facts
are equally valuable to the average investor.
5. The Economist, published in England, gives an excellent
survey of British and international economic developments and
contains statistics on commodity production and prices.
6. The Financial World is devoted to investment advice and
information on a wide variety of securities, companies, and in-
dustries.
7. United States News and World Report covers political and
economic developments and trends, as well as reprinting the offi-
cial texts of important political speeches and government reports.
Monthly business and financial periodicals. With the exception
of the Magazine of Wall Street, issued biweekly, the following are
monthly journals of considerable interest. They cover a wide
field.
1. Bulletins of commercial banks, such as the National City
Bank (New York) Letter, the Cleveland Trust Company Business
Bulletin, and the Guaranty Survey, contain critical and descrip-
tive material on economic and business trends and the capital
markets.
2. Monthly reviews or bulletins of the several Federal Reserve
Banks, covering monetary, fiscal, and business conditions.
3. Credit and Fituincial Management is devoted primarily to
short-term financing.
4. Dun's Review, published by Dun & Bradstreet, emphasizes
trade indexes and failure data. The well-known Dun & Bradstreet
14 financial ratios are published periodically.
5. The Exchange, published by the New York Stock Exchange,
gives information concerning securities listed on the "Big Board."
6. Federal Reserve Bulletin, published by the Board of Gov-
ernors of the Federal Reserve System, reviews banking and finan-
cial developments and provides a wealth of statistical information,
both domestic and foreign, on money, credit, banking, and busi-
ness. This is a basic source.
7. Fortune presents in a unique fashion the picture of Ameri-
can business enterprise. Its discussion of domestic and foreign
business and economic problems and its articles on an industry, a
business, or a business executive, are colorful and comprehensive.
8. Magazine of Wall Street (biweekly) discusses industries and
companies and makes specific investment recommendations.
9. National Industrial Conference Board Business Record sur-
veys business trends and provides many business indices that
indicate the direction of business activity.
10. Nation's Business, published by the United States Chamber
of Commerce, contains articles on general business subjects from
the standpoint of the business executive.
11. Survey of Current Business, published by the United States
Bureau of Foreign and Domestic Commerce, provides detailed
material on the trend of business in the nation that is invaluable
as background. Each issue contains a very complete compendium
of business statistics, which are kept current in a Weekly Supple-
ment. An Annual Review is published in February.
Quarterly investment and financial periodicals. Two additional
publications deserve mention.
1. The Analysts Journal, published by the New York Society
of Security Analysts, is devoted to analytical methodology.
2. The Journal of Finance, published by the American Finance
Association, contains articles on investment, business finance,
money and credit, and international finance.
Banking periodicals. Although they are published primarily for
those interested in banking, these periodicals contain material of
interest on bank securities and bank investment policy. (See also
the Federal Reserve Bulletin and the monthly bank bulletins men-
tioned above.)
1. American Banker, a daily, supplies news of bank activities
and legislation and a list of bank stock quotations.
2. Banking, the official monthly magazine of the American
Bankers Association, contains articles on bank trends and prac-
tices.
3. Burroughs Clearing House is published by the Burroughs
Adding Machine Company.
4. Savings Bank Journal is a monthly publication dealing with
savings banking.
5. Trusts and Estates and The Trust Bulletin, both monthly
magazines, cover primarily the administration of trust funds.
General periodicals. Two weekly news magazines, Time and
Newsweek, contain excellent business sections, with emphasis
on interesting developments in specific companies.
Information on United States Government securities. The pri-
mary sources of information on United States securities are the
official reports of the Treasury Department:
1. Circular giving specific information on each issue prepared
at the time of issue.
2. Daily report of Treasury operations showing revenue and
disbursements for year to date and the amount of the Federal
debt.
3. Treasury Bulletin, a monthly publication showing the com-
position and ownership of the Federal debt, market quotations
and yields, and financial and fiscal data.
4. Annual report of the Secretary of the Treasury, giving a
comprehensive picture of Federal fiscal operations during the
year.
5. Annual reports of the various government corporations and
credit agencies whose securities are included in the federal cate-
gory, such as the Farm Credit Administration (Farm Mortgage
Corporation, Federal Land Banks, Federal Intermediate Credit
Banks), Reconstruction Finance Corporation, Commodity Credit
Corporation, and the Federal National Mortgage Association.
The secondary sources of information on United States Gov-
ernment securities (in addition to the statistical services and other
sources mentioned elsewhere) include:
1. Securities of the United States Government and Its Instru-
mentalities, published intermittently by the First Boston Cor-
poration.
2. Concerning United States Government Securities, published
in 1947 by C. F. Childs & Co., Chicago. The same firm publishes
the Investment Bulletin (monthly), which is chiefly concerned
with Federal obligations.
3. United States Government Securities, published annually
by C. J. Devine and Co. (New York).
4. United States Government Securities and the Money Market,
published annually by Bankers Trust Company, New York.
5. Governmental Finances in the United States, published an-
nually by the Department of Commerce, Bureau of the Census.
Includes "Governmental Debt" and "Governmental Revenue."
Information on state securities. The primary sources of infor-
mation on securities issued by state governments are the annual
reports prepared by the financial officers of the respective states.
These reports vary from a brief financial statement to a compre-
hensive booklet such as that issued by the Comptroller of New
York State.
The secondary sources (other than the statistical services and
others mentioned elsewhere in this chapter) include:
1. Annual publications of the United States Department of
Commerce, Bureau of the Census: Summary of State Government
Finances; Compendium of State Government Finances; Sources
of State Tax Revenue; and Governmental Debt.
2. Publications of The Tax Foundation, New York.
3. Resources and Debts of the Forty-eight States, prepared at
irregular intervals by Dun and Bradstreet.
4. State and Municipal Compendium, issued semiannually by
The Commercial and Financial Chronicle.
5. State and Municipal Securities, published by C. J. Devine
and Co., New York.
Information on municipal securities. The primary sources of
information on securities issued by municipal governments are
the annual reports of the respective financial officers. Some of
these are quite comprehensive.
The secondary sources (other than those mentioned elsewhere)
include:
1. The Blue List of Current Municipal Offerings, a daily com-
pilation of offerings of the larger municipal bond houses.
2. Annual publications of the United States Department of
Commerce, Bureau of the Census: Compendium of City Govern-
ment Finances; Large-City Finances; Governmental Debt.
3. Dun & Bradstreet, Inc., publishes Municipal Credit Surveys
on obligors having a substantial amount of debt outstanding.
4. State and Municipal Compendium (see information on state
securities, above).
5. Special reports of state tax commissions, such as those for
New York State, which give a detailed picture of the financial
condition of each town, city, and county in the state.
6. Prospectuses and special releases of investment banking
houses interested in municipal securities.
7. Publications of The Tax Foundation, New York.
8. State and Municipal Securities, published by C. J. Devine
and Co., New York.
Information on industriesgeneral. It is impossible to indicate
here all of the many sources to which the investor may turn for
information concerning industries in which he may be interested.
The following classifications should, however, prove useful and
suggestive. They cover a wide range. (More specific sources on
special classifications of industries and companies are indicated
after these comprehensive sources are outlined.)
1. Business and financial periodicals (see above).
2. Government publications and documents. An amazing mass
of information on many industries is available in government re-
leases, especially information of a statistical character and in-
formation on regulated groups. Special mention should be made
of Department of Commerce publications, such as Facts for In-
dustry, Industry Reports, Survey of Current Business, Foreign
Commerce Yearbook (annual), Statistical Abstract, Census of
Manufacturers, and Census of Business; Minerals Yearbook is
published by the United States Bureau of Mines. Reports of regu-
latory commissions having to do with railroads and utilities and
banks will be indicated below. Others include reports of the
Federal Trade Commission, the Maritime Commission, and the
Securities and Exchange Commission. Special governmental hear-
ings and investigations, such as the hearings and monographs of
the Temporary National Economic Committee, are useful but
irregular in appearance. The reader is advised to consult the
monthly and annual catalogs of the United States Superintendent
of Documents for additional sources.
3. Trade association publications. Many trade associations com-
pile and publish statistical material that indicates the conditions
and trends in various industries. Examples are the annual review
or statistical issues of the American Iron and Steel Institute, the
American Meat Institute, the National Lumber Manufacturers
Association, the United States Copper Association, the American
Petroleum Institute, and the Rubber Manufacturers Association.
A complete list of trade associations is found in the Department
of Commerce publication National Trade and Professional Asso-
ciations.
4. Trade journals. Magazines devoted to special industries are
excellent sources of information in their respective fields. A great
many might be mentioned, but the following are representative:
American Gas Association Monthly; Automotive Industries; Con-
ner; Coal Age; Electrical World; Food Industries; Iron Age; Na-
tional Petroleum News; Oil and Gas Journal; Public Utilities Fort-
nightly; Railway Age; Rayon Organon; Textile World; and Steel.
A number of trade journals publish annual statistical or review
bulletins.1
5. Reports of statistical and rating services (see pages 195 to 197).
The "blue sections" in Moody's Manuals are especially valuable.
6. Reports of private agencies. Certain private agencies spe-
cialize in statistical information concerning specific industries.
Examples are F. W. Dodge Corporation (Dodge Statistical Re-
search Service), Ward (Automotive Reports), and Alfred M.
Best Co. (Best's Insurance Reports).
7. Reports of investment advisory services. In addition to re-
ports and appraisals of specific companies, industries and their
trends are appraised in certain general investment and business
services, such as United Business Service, Babson's Confidential
Barometer Letter, The Value Line, and others.
8. Reports and brochures of brokerage and investment banking
firms. As a part of their service to clients, such firms frequently
prepare special industry studies that are available at their offices
or by mail.
1 For a complete list, see Special Libraries, November, 1945 (New York: Special
Libraries Association).
Information on companies and their securitiesgeneral. In
addition to the material noted below concerning special groups of
companies, the following sources include information on a wide
variety of types:
1. Annual and interim reports to stockholders.
2. Prospectuses issued when new securities are offered.
3. Business and financial periodicals (see above).
4. Advisory services, such as United Business Service, Babsons,
Brookmire, The Value Line, Investographs, and many others,
analyze industries and companies and make recommendations to
their subscribers for the purchase, holding, or switching of se-
curities.
5. Reports of statistical and rating services (see below).
6. Reports of brokerage and banking firms issued regularly or
intermittently, often including recommendations for purchase.
The statistical and rating services. Three large statistical serv-
ices, Moody's, Standard and Poor's, and Fitch, are engaged pri-
marily in the publication of statistical data, for the guidance of
investors, concerning all corporations in which there is consider-
able investment interest. One or two other services specialize in
regional or industrial groups. In addition to providing financial
data, the services rate the more important securities by symbols
such as AAA or A1+, AA or Al, and so forth. Such ratings are
useful guides in the selection of suitable securities, but investors
professing an ability to judge quality find them to be useful chiefly
in confirming or challenging their own appraisals.
The more important offerings of each of these services that are
of interest to individual investors are outlined below:
1. Moody's:
a. Annual Manuals: Government and Municipals; Banks, In-
surance, Real Estate, Investment Trusts; Industrials; Public Utili-
ties; Railroads. The history, statements, security prices, and divi-
dend record of a very large number of concerns are presented.
The central "blue sections" provide valuable data concerning
these industrial groups as a whole. The manuals are kept current
by semiweekly supplements.
b. Bond Survey; Stock Survey: weekly information on market
trends, industries, companies, and investment recommendations.
c. Bond Record, a pocket guide (semimonthly) of price and
earnings, including ratings, of some 12,000 bonds.
d. Dividend Record, a semiweeklv and cumulative record of
dividend action.
e. Advisory Reports.
2. Standard b- Poor's:
a. Standard Corporation Records, factual information on a wide
variety of companies, in loose-leaf form, kept up to date by a daily
and weekly News Section and a daily and weekly Dividend Sec-
tion.
b. Industry Surveys, compilations of group data on a number
of individual groups of industries and leading companies in each.
c. Outlook for the Securities Markets, a weekly forecast of the
market, with recommended industries and securities.
d. Trade and Securities Statistics, a wide variety of indexes of
prices, wages, production, security values, and other economic
data.
e. Railroad Securities Service.
f. Bond Outlook, a weekly issue discussing the trends in interest
rates and in the bond market, with short reports and recommen-
dations on individual corporate and municipal issues.
g. Facts and Forecasts, daily information on the markets, com-
panies, and securities, with recommendations.
h. Listed Bond Reports; Listed Stock Reports: two-page de-
scriptions and financial information on listed securities, with
approximate recommendations.
i. Unlisted Bond Reports; Unlisted Stock Reports: analyses of
securities that are traded over the counter.
j. Monthly Earnings and Stock Rating Guide, earnings and
price data and buying, hold, or switch ratings on some 5,000
stocks; pocket-sized.
k. Bond Guide (semimonthly), price and earnings data, pocket-
sized.
1. Called Bond Record, current lists of dates and provisions of
bond redemptions.
3. Fitch:
a. Corporation Manuals: loose-leaf manuals of financial and
other information kept up to date by a daily news and dividend
section.
b. Bond Book, an annual containing descriptions and ratings of
corporate and government bonds.
c. Trade, Industry and Security Service, analyses of important
industries and representative companies.
d. Bond Record; Stock Record: pocket-sized manuals giving
current ratings, price, yield, earnings, and dividend information.
e. Weekly Market and Business Review and Forecast contains
specific recommendations.
f. Stock Bulletins; Bond Bulletins; Unlisted Securities Service:
one-page descriptions of companies and securities, with recom-
mendations.
4. Other services:
a. Walkers Manual of Pacific Coast Securities, annual, kept
current by a Weekly News Letter and Field Report.
b. Robert D. Fisher Mining Manual.
c. Arthur Wiesenberger, Investment Companies (see below).
Information on railroads and railroad securities. The primary
sources of information (in addition to annual and interim reports)
are:
1. Monthly reports of earnings to the Interstate Commerce
Commission, which reports usually appear in the newspaper in
summary form.
2. Annual Report on the Statistics of Railways in the United
States, by the Interstate Commerce Commission. (Popularly
known as the "I. C. C. Blue Book.") Contains complete statistical
information on every phase of operation and finance.
3. Numerous other reports and releases of the I. C. C, includ-
ing freight commodity statistics and monthly forecasts of earn-
ings. Upon request, the Commission will send the investor a list
of its various publications.
The secondary sources (other than the statistical services, trade
journals, and other sources previously mentioned) are:
1. A Review of Railway Operations, an annual survey of rail-
way operations prepared by the Bureau of Railway Economics
of the Association of American Railroads. The same source pub-
lishes a monthly report on railway revenues and expenses and
Statistics of Railways of Class I, an annual compilation.
2. Railroad Data, a periodical featuring current railway sta-
tistics, developments, and problems, published semimonthly by
the Committee on Public Relations of the Eastern Railroads.
3. A Yearbook of Railroad Information, a statistical and graphic
study of railroad operations prepared annually by the Eastern
Railroad Presidents' Conference Committee on Public Relations.
Also published as Railroad Facts by the Western Railways Public
Relations Office.
4. Equipment Trust Securities, a statistical study prepared
annually by Freeman and Company.
5. The Railway and Industrial Compendium, a statistical anal-
ysis of corporate earnings, published by the Commercial and
Financial Chronicle; the railway sections are issued semiannually
in May and November.
6. Moody's Manual of Investments, Railroads (referred to
above), "blue section" on the industry with data on traffic, rev-
enues, expenses, securities, and finances.
Information on public utilities and their securities. In addition
to annual and interim company reports, the primary sources in-
clude:
1. Financial statements filed with the S. E. C. annually under
the provisions of the Securities Exchange Act.
2. Annual reports of the Securities and Exchange Commission
with particular regard to the enforcement of the provisions of the
Public Utility Act of 1935.
3. Special releases and reports of the S. E. C, for example,
Financial Statistics for Electric and Gas Subsidiaries of Registered
Public-Utility Holding Companies; Security Issues of Electric and
Gas Utilities.
4. Annual reports of the Federal Power Commission and the
Federal Communications Commission.
5. Special reports of the Federal Power Commission, such as
The Financial Record of the Electric Utility Industry; Statistics
of Electric Utilities in the United States (annual); and Statistics
of Natural Gas Companies.
6. Monthly report on electric power production, Federal Power
Commission.
7. Annual reports of the respective state public service com-
missions.
The secondary sources of information on public utility securities
(except the general and statistical sources previously mentioned)
are:
1. The Public Utility Compendium, a corporate manual issued
semiannually by the Commercial and Financial Chronicle.
2. Annual report on the output and capacities of the principal
electric power companies, compiled by the Electrical World.
3. Weekly and monthly reports on the outputs of the larger
electric power systems compiled by the Edison Electric Institute.
See also the Institute's annual Statistical Bulletin.
4. Monthly report on the sale of manufactured and natural gas,
prepared by the American Gas Association.
5. Bell Telephone Securities, an annual publication prepared
by the American Telephone and Telegraph Company covering
all securities issued by companies in the Bell System.
6. Annual Proceedings of the National Association of Railroad
and Utilities Commissioners.
7. Moody's Manual of Investments, Public Utilities (referred
to above), "blue section" devoted to output and services, earnings
and expenses, financing, regulation, and other utility matters.
Information on financial institutions and their securities. In
addition to the general sources mentioned earlier in the chapter,
the following are of value:
Commercial banks:
1. Quarterly reports or "Statements of Condition."
2. Comparative analyses of bank statements prepared by in-
vestment dealers, notably Blyth & Co., Inc., and Geyer & Co.
3. Annual reports of the Comptroller of the Currency (United
States Treasury Department) and of state banking departments.
4. Annual reports of the Federal Deposit Insurance Corpora-
tion.
Insurance companies:
1. Best's Insurance Reports (annual): Life, Casualty Surety
and Miscellaneous, Fire and Marine volumes, contain financial
data on stock and mutual companies, with ratings.
2. The Spectator Insurance Yearbook (annual): Life, Fire and
Marine, Casualty and Surety volumes, provide balance sheets and
profit-and-loss statements of individual companies.
3. Best's Fire and Casualty Aggregates and Averages (annual).
4. Best's Digest of Insurance Stocks (annual).
5. Comparative analyses of statements of leading companies
prepared by investment dealers, such as the annual Insurance
Stock Analyzer, published by Geyer & Co.
6. Releases of the Institute of Life Insurance (New York),
especially Life Insurance Fact Book (annual).
Investment companies:
1. Reports and prospectuses of investment companies showing
portfolios in detail.
2. Releases and brochures of investment companies and dealers,
showing performance of shares.
3. Investment Companies, published annually by Arthur Wies-
enberger and Co., New York, comparing the performance of ap-
proximately 150 funds.
4. Investment Trust Stockholders' Service, a monthly and quar-
terly analysis of the performance of leading investment companies,
published by the American Institute for Economic Research.
5. Trusts and Estates, regular comment on performance of funds.
6. Barron's (weekly), section on Investment Funds.
Savings and loan associations:
1. Annual reports of the Federal Home Loan Bank Board, and
2. Annual reports of the Federal Savings and Loan Insurance
Corporation. Both of these are included in the reports of the
Housing and Home Finance Agency.
3. Annual reports of the state building and loan commissioners.
4. Publications of the United States Savings and Loan League
and the National Savings and Loan League. The former's Savings
and Loan News is particularly interesting.
Information on real estate securities. Primary information on
real estate securities is rarely available to investors, except from
annual reports of a relatively few companies. Chief reliance must
be placed on such sources as Moody's Manual of Investments,
Banks, Insurance, Real Estate and Investment Trusts; Fitch's
Corporation Manuals; and Standard and Poor's Corporation Rec-
ords. Mortgage Banker is a monthly publication devoted to real
estate mortgage financing.
Information on foreign securities. Investors are handicapped
by a dearth of primary information on securities of foreign cor-
porations and governments. Where publicly offered in the United
States, prospectuses as required by the S. E. C. are available.
Some information is found in the statistical manuals and financial
journals. The Institute of International Finance of New York
University issues bulletins on the foreign debt situation. The
Foreign Bondholders Protective Council is a private organization
designed to help investors in foreign securities; its annual reports
are of considerable interest. There is, of course, a mass of informa-
tion on fiscal and trade conditions abroad in a wide variety of
sources.
Security market forecasts. Opinion concerning the course of
bond and stock prices abounds in great profusionin financial
papers and journals, in the publications of statistical and advisory
services, and in the releases of brokerage and investment banking
firms. The degree to which the investor will rely on such informa-
tion will depend on his need for advice and his confidence in the
source.
Investment advice. The investor who is unwilling or unable to
follow business and economic developments and make his own
investment selections has at his disposal a number of sources of
investment advice. He may obtain "free" advice from representa-
tives of investment and brokerage houses. Such advice is often
very valuable, although these firms are in the business of retailing
securities or turning over orders. He may rely on the opinions of
his commercial bank. He may subscribe to the services of organi-
zations that make a business of selling advice along with or as
distinguished from statistical information. (Some of these services
have been mentioned earlier in this chapter.) These firms, as a
general rule, do not manage or supervise the accounts of clients
but make recommendations which subscribers are at liberty to
accept or reject. In this important respect they differ from invest-
ment counsel firms, which are in the business of supervising the
accounts of their clients.
The growth of investment counsel firms has been a noteworthy
development of recent years. Generally speaking, such firms are
interested only in fairly large accounts; an annual fee of, say, 1
per cent of the value of a fund is lucrative only if the fund is
substantial. The minimum fee of $500 to $1,000 annually is pro-
hibitive to the small investor. Many investment counselors are
doing a capable job in a field where infallibility and exact meas-
urements are unknown. The ability of others to attract clients has
been somewhat discouraged by the passage of state and federal
regulation. The states protect chiefly against fraud. The Invest-
ment Advisers Act of 1940 subjects investment counselors to
federal control. All professional investment advisors (with certain
exceptions) are required to register with the Securities and Ex-
change Commission, giving information concerning their organiza-
tion and operation, education and qualifications, nature and scope
of authority over clients' funds, their fees, and other details. Fees
based on a percentage of capital appreciation are prohibited, and
deceptive and fraudulent actions are made the basis of severe
penalties.
CHAPTER 13
INTERPRETING THE FINANCIAL PAGE
Scope. The purpose of this chapter is to discuss in interpretative
fashion the financial news which appears in the daily newspapers.
The order of discussion is: (1) financial reporting, (2) bond price
quotations, (3) listed stock price quotations, (4) over-the-counter
quotations, (5) activity in the security markets, (6) security price
averages, (7) money rates, (8) business and price indexes, (9)
corporate earnings reports, (10) commodity prices, (11) miscel-
laneous information. It is the duty of every investor to keep in
touch with economic and financial developments. The least he
can do in this connection is to read the financial page intelligently.
Financial reporting. Every important American newspaper
now includes a financial news section. In striking contrast to the
practice of confining financial news to a single page, which was
customary during the early decades of the present century, the
larger newspapers now devote several pages of their daily issues
to business news. Investors are thus afforded a chance to keep
constantly informed on developments which are of major signifi-
cance to the position of their securities.
The information contained in the financial section of the papers
is either statistical or general. The statistical news comprises price
quotations on securities and commodities as reported on the var-
ious exchanges and markets, as well as financial reports released
by public and private institutions. The general news consists of
comments on developments throughout the business world, with
particular regard to the trend of prices in securities and com-
modities.
The news items which appear on the financial pages have not
been compiled by the paper, as a rule, but have been supplied in
the form of formal statements and "news releases," prepared, in
many instances, by the publicity departments of the institutions
203
204 INTERPRETING THE FINANCIAL PAGE
concerned. As time is of the essence in news reporting, and as
such information is usually received from reliable sources, these
items are usually published without editorial revision beyond that
required by limitations of space.
Price quotations on securities are secured by the papers, in the
case of listed issues, from reporting services such as the mechanical
price "tickers" which are operated from the securities exchanges.
In the case of unlisted issues, quotations are obtained from in-
vestment firms which maintain markets in such issues and from
the National Association of Securities Dealers.
Supplementing the work of the great newsgathering organiza-
tions such as the Associated Press and the United Press, which en-
deavor to cover all news items of general interest, the Dow-Jones
service is devoted entirely to the field of finance. Items obtained
by Dow-Jones reporters and correspondents who are located in
the principal cities of the world are disseminated by means of
mechanical news printers and bulletin sheets, as rapidly as re-
ceived, to subscribing financial institutions and newspapers.
Quotations on United States Government obligations. United
States Treasury bonds are listed on the organized exchanges, but
the bulk of the trades are in large amounts and take place over-
the-counter. These bonds are quoted in percentages of par value,
with fractions in thirty-seconds of a point. The unit of trading
on the New York Stock Exchange is $1,000 par value, but price
quotations are in terms of $100 of principal. For example, the
following information on a specified Treasury bond appeared in
the financial section of the New York Times on August 16, 1951,
reporting transactions as of August 15:
Net Change
Bid Asked in Bid
'2Xs 1959-56 Sept. 101.2 101.6 +.4
These bonds bore a 2& per cent interest rate and were payable
in September 1959, but were redeemable by the Government at
any time between September 1956 and 1959. The best bid at the
close of the Exchange was 101 %.,, or $1,010.62, and the best offer
was 101%2, or $1,011.87. The bid was up Y32 from the closing bid
of the previous day. The asterisk () denoted that the income
from this issue is fully subject to Federal income taxes.
INTERPRETING THE FINANCIAL PAGE 205
Treasury notes, which represent debt of from one to five years
in maturity, are similarly quoted in thirty-seconds, but certificates
of indebtedness and treasury bills, also traded exclusively over-
the-counter, are quoted on a percentage-of-yield basis. For ex-
ample, on the date referred to above, the following quotation on
Treasury certificates appeared:
Outstanding
Millions Rate Bid Ask Yield
5.253 Nov.,'51 IX 1.26 1.18 1.18
These obligations, due in November, 1951, were priced to yield
1.26 per cent on a bid basis, while the best asked price, at the close
of the Exchange, was higher and produced a yield of 1.18 per cent.
Listed bond price quotations. Foreign bonds and domestic cor-
poration bonds that are listed on the New York Stock Exchange
and the New York Curb Exchange are quoted in percentages of
par, in eighths of a point. For example, on the same date as above,
the following appeared under the general heading of "Bond Trad-
ing on the New York Stock Exchange":
DOMESTIC BONDS
Range
1951 Sales in Net
High Low $1,000 High Low Last Chge.
82% 67 Balt&O 5s 95 G 12 71K 71 71
The price of Baltimore and Ohio 5 per cent bonds, series G, due
in 1995, ranged from a high of $827.50 per $1,000 principal value
to a low of $670.00 during the period January 2 to August 15,1951.
On August 15, transactions totalled $12,000. The highest price at
which a trade took place during the day was at $711.25 per bond;
the lowest, at $710.00. The closing price of $710.00 represented
no change over the closing price on August 14, which was also
$710.00.
Numerous abbreviations are used in bond titles appearing on
quotation pages and elsewhere, of which the following are most
commonly found:
adj., aj adjustment
asd., asstd assented
clt., col., col. tr collateral trust
con., cons consolidated
C, cou., coup coupon
ct, cv., conv convertible
deb debenture
div divisional
eq., equip equipment
ext extension
t -flat
g -gold
gen general mortgage
gu-, gtd -guaranteed
irnp improvement
inc income bonds
int. ctfs interim certificates
jt joint
m., mtg mortgage
p m purchase money
perp perpetual
pr. In .' prior lien
re., real est real estate
ref-. rfg -refunding
r-, reg registered
ser series
s-f sinking fund
st stamped
war warrants
w w with warrants
x w without warrants
1st 4 s first mortgage 4 per cent bonds
'61 -due in 1961
65-62 -due in 1965, may be paid 1962 to 1965
Listed stock price quotations. Quotations of listed stocks are
fairly well standardized, and about the same methods are used
for the reporting of transactions on all of the exchanges. The fol-
lowing information on a leading industrial common stock which
is listed on the New York Stock Exchange is also taken from the
New York Times on August 16, 1951, covering transactions on
August 15:
Range
1951 Stock and Div'd Shs. Net
High Low in Dollars 100's First High Low Last Change
58 51S Sears Roeb 2a 22 54 54 53H 54 + %
The price of Sears Roebuck common stock from January 2, 1951,
to August 15, 1951, ranged from a high of $58 per share to a low
of $51/2 per share. The current annual dividend rate was $2 per
share, based on the last quarterly or semiannual declaration.
(Sometimes the dividend is the amount declared or paid thus far
in the year and is so indicated by a footnote designation.) The "a"
referred to a footnote: "Also extra or extras." The total volume of
sales on August 15 was 2,200 shares. The opening transaction was
at $54 a share, the highest during the day was at $54, the lowest
was at $53.50, and the last sale before the close of the trading day
was at $54. This was % of a point higher than the last closing price
on the previous trading day.
Unless otherwise designated, the quotation refers to the com-
mon stock of the company. Quotations on preferred stocks are
indicated by "pf." Other abbreviations and symbols frequently
used in stock quotations and elsewhere are as follows:
com common
ct., ctfs., vtc voting trust certificates
cv - convertible
ex d., xd -ex dividend
ex r., xr -ex rights
gtd guaranteed
pf preferred
pr. pf prior preferred
w.i when, as, and if issued
Quotations on listed stocks (and bonds) not traded in on the
exchange on a given day are found in a separate section and are
in terms of bid and asked prices. The major New York dailies also
report closing prices on a selected list of stocks on "out-of-town"
exchanges.
Over-the-counter quotations. Although the securities of the
largest and best-known companies are listed, most securities are
not listed but are traded in the open market or "over-the-counter."
In addition to the Federal obligations previously mentioned, this
group includes: bonds of United States Government instrumen-
talities that are fully guaranteed by the Government; bonds of
Federally sponsored agencies, such as the Federal Land Banks;
state and municipal bonds; railroad guaranteed stocks and equip-
ment obligations; bank, insurance company, and investment com-
pany stocks; real estate securities; foreign securities (other than
those listed); and a host of industrial, utility, and railroad bonds
and stocks.
Quotations of local over-the-counter securities are obtained
from dealer-broker houses, and the National Association of Se-
curities Dealers, Inc., makes available daily and supervises the
quotations for a large number of securities. The number of such
quotations varies from a long list in the major dailies and special
financial newspapers to a short list in smaller local dailies.
Over-the-counter quotations are confined to bid and asked
prices, together with dividend information (in the case of stocks).
The bid price on the previous day is sometimes shown.
Other information on security prices and volume of trading.
In addition to price quotations, the larger newspapers give daily
information concerning the volume of trading on the last day of
tradingthe volume of stocks in shares and of bonds in dollars.
Usually the day's figures are compared with those for the equiva-
lent day of the previous year, and the cumulated total for the year
to date is shown.
The day's leadersthe stocks with the most shares tradedare
often itemized in a separate table in the financial section, together
with the number of issues traded that day on the particular ex-
change, the number of advances and declines from the previous
day, and the number of new highs and new lows for the year to
date. It is interesting to note that even on a day of great activity
and a general rise in shares, some make their new lows for the
year. Seldom if ever have all stocks or bonds moved in the same
direction on the same day.
Security price averages. A number of indexes or averages have
been constructed to represent large groups of securities or the
market as a whole. The most widely published are the Dow-Jones,
Standard & Poor's, and the New York Times averages. Most good
financial pages will show one of these.
In addition to five bond averages, Dow Jones & Co. publishes
four stock price indexes at the opening and close and at each hour
of the New York Stock Exchange day: 30 industrials, 15 utilities,
20 railroads, and the composite of the 65. Such averages enable
the reader quickly to observe the trend in prices more reliably
than observing the movement of a few leading issues. It is dan-
gerous, however, to assume that such averages are fully repre-
sentative. During the year 1949, for example, the Dow-Jones in-
dustrial average rose from 161.60 to 200.52. However, of the 1400
stock issues listed, over three hundred actually declined during
the year.
Price averages are also designed to indicate the trend of the
market by classes of securities. Some newspapers show separate
averages for utility, oil, steel, food, motor, and other groups of
stocks and thus enable their readers to compare the prices of any
particular group with the general trend of the market.
DOW-JONES AVERAGES
Closing Pricks on Representative Common Stocks (as computed daily)
Year
30 Industrials
20 Railroads
High
Low
High
Low
1925
159.39
115.00
112.93
92.98
1926
166.54
135.20
123.33
102.41
1927
202.40
152.73
144.82
119.29
1928
300.00
191.33
152.70
132.60
1929
381.17
198.69
189.11
128.07
1930
294.07
157.51
157.94
91.65
1931
194.36
73.79
111.58
31.42
1932
88.78
41.22
41.30
13.23
1933
108.67
50.16
56.53
23.43
1934
110.74
85.51
52.97
33.19
1935
148.44
96.71
41.84
27.31
1936
184.90
143.11
59.89
40.66
significance as an indicator of interest in the securities markets.
The rate averaged 1.63 per cent in 1950.
Commercial paper (prime names, 4 to 6 months)2% to 2&%.
Rates on this "businessmen's paper," issued through commercial
paper houses, are representative of the short-term money market.
They were as high as 6 per cent in 1929 and as low as %% in 1935.
Bankers' acceptances1%% to 1%%, 30 to 90 days. These are the
rates in bankers' bills and are normally the lowest non-govern-
mental rates in the short-term money market. They were as high
as 5&% in 1929 and as low as %% in 1935.
Discount rates1%%. This was the rate on advances by the New
York Federal Reserve Bank to member banks secured by United
States Government securities. The rediscount rate, formerly a
powerful tool of credit control, has lost much of its effectiveness
in recent vears.
Treasury notes1.84%. This was the effective rate of return ob-
tainable from the purchase of United States Treasury Notes due
in four years. (Notes are issued from one to 5 years in maturity.)
The rate in August, 1951, was low. But it had been as low as .6 per
cent in 1941.
Treasury bills1.62%. This was the yield at the asked price of
short-term Treasury obligations due in three months. Treasury
bills are issued on a discount basis to mature in 90 to 92 days.
Treasury bonds2.58%. This was the effective rate of return
obtainable from the purchase of United States Treasury bonds of
the longest maturity outstanding. This rate on Treasury bonds is
the most important interest rate in the money market from the
investment viewpoint. It is the common denominator of all in-
vestment values and provides a continuous standard representing
the riskless rental value of money. The spread between other yields
and the yields on Treasury bonds of similar maturity represents
a reward for risk. The investor must decide whether the spread
is satisfactory.
Business and price indexes. The state of business activity
throughout the country is measured by means of a variety of index
numbers that are now compiled by both public and private agen-
cies and that are available in the leading newspapers. Probably
the most widely quoted of these is the monthly index of industrial
production, published by the Board of Governors of the Federal
Reserve System. This index uses as a 100 per cent base the average
degree of activity that prevailed over the five-year period from
1935 to 1939 inclusive. The figure was 223 in May, 1951. It had
been 110 in 1929 and reached a low of 58 in 1932. The all-time
high was 247 in October, 1943.
Many other indexes are often reported from time to time in the
financial press. The indexes of cost of living, wholesale prices, and
retail prices, such as those prepared by the Bureau of Labor
Statistics of the Department of Labor, are among those most
widely quoted. Special financial and business journals are, of
course, much better sources of such indexes than are the daily
papers.
Corporate earnings reports. In addition to the annual reports
of earnings which corporations customarily issue, interim reports
on a semiannual or quarterly basis are now published by the great
majority of the more important companies. This information,
which is summarized in the newspapers, allows investors to keep
in close touch with the earnings records of companies in which
they are interested and helps them to act quickly if necessary for
the protection of their interests.
Investors should make proper allowance for seasonal influences
upon interim reports. Earnings for the first quarter of the year are
rarely a dependable guide for the entire year. Because of increased
volume of crop movements during the harvest months, earnings
of railroad companies during the second half of the year are gen-
erally much better than during the first half.
Commodity prices. The larger newspapers report regularly the
prices of the more important commodities. Quotations on wheat,
corn, rye, oats, flour, coffee, cocoa, sugar, butter, lard, various
metals, textiles, rubber hides, crude oil, and others are found regu-
larly in the more important metropolitan papers. The sources of
these quotations are the various organized commodity exchanges,
such as the Chicago Board of Trade, the New York Cotton Ex-
change, and the New York Produce Exchange.
Other information. Depending on the scope of the particular
financial page, a very wide variety of business and financial news
is reported in the daily press. A glance at the New York Times
reveals information on the Outlook for various industries, banking
and credit, Treasury and municipal financing, foreign business
and economic developments, notes on corporate developments,
carloadings and other industrial activity, consumption, trade and
transportation developments, new security offerings, dividend
announcements, foreign exchange rates, shipping news, and notes
on business personalities.
Summary. Systematic reading of the financial page will go far
toward explaining the forces that bear upon the securities markets.
At the same time, the investor must cultivate the ability to dis-
criminate between the vital and the unimportant, the petty and
the significant. Nor should sole reliance be placed on the rather
shallow and superficial material that comprises much of the daily
financial section. Systematic study of the more specialized sources,
such as those indicated in the previous chapter, is necessary for
a really sound investment judgment.
CHAPTER 14
INVESTMENT BANKING
Scope. The purpose of this chapter is to discuss the process of
origination and distribution of the new securities which are offered
to the public. It will be chiefly concerned with the work of in-
vestment banking houses and with the regulation of their activities
in connection with the marketing of corporate issues. The order
of discussion is: (1) direct selling and private placement of securi-
ties, (2) functions of investment banks, (3) types of investment
firms, (4) their internal organization, (5) private negotiation and
competitive bidding, s(6) the buying function, (7) underwriting,
(8) prices and commissions on securities, (9) "best-efforts" sell-
ing, (10) "stand-by" underwriting, (11) selling the securities,
(12) other services, (13) Federal regulation, (14) state regu-
lation.
Direct sale of securities. New securities are placed in the hands
of investors either through direct sale or through investment bank-
ing houses. Direct selling is employed by the Federal Government
in the issue of new obligations to the general public. Direct selling
is also employed by new, weak, and speculative concerns that
cannot obtain or cannot afford the services of an investment
banker. Sale of securities to employees and customers is also di-
rect, as is the sale of new stock or convertible bonds to present
stockholders by privileged subscription. (The offer of stock by
rights is described in Chapter 17.) In many cases, however, the
issuing corporation may have the successful sale of securities
through rights guaranteed or underwritten by investment bankers,
under a "stand-by" agreement that will be described later in this
chapter.
Direct selling also takes the form of "private placements,"
whereby a corporation sells bonds in large blocks to large invest-
ing institutions, such as life insurance companies, without utilizing
213
214
INVESTMENT BANKING
the services of the investment banker or middleman. Over 40 per
cent of corporate bond offerings, consisting of high-grade securi-
ties, are now thus privately offereda situation that has become a
matter of serious concern to investment bankers.1 The growth of
private placement is attributable in part to the requirements of
the Securities Act of 1933 with respect to issues publicly offered,
particularly because of the work, expense, and possible liability
incurred in registration of new issues and the uncertainty that
accompanies the required waiting period that precedes the public
offering. In addition, private placement eliminates the under-
writing commission of the investment bankers. A technical disad-
vantage is found in the ineligibility of such securities for resale to
the public at a later date until the proper registration procedure
is then completed. The major disadvantage, however, lies in the
fact that the investing public is not only prevented from partici-
pating directly in the better quality of new issues which are pre-
empted by relatively few large institutions, but also is deprived,
through refunding operations, of bonds called for redemption
with the proceeds of new issues privately placed.
The remainder of this chapter is devoted to the distribution of
securities through investment bankers and to the internal organiza-
tion and operation of investment firms.
Economic function of investment banking. The investment
banker is a middleman, the intermediary between the govern-
mental or business issuer of securities and the investing public.
Through him new capital is obtained in large volume. To a large
degree he determines the channels into which savings are directed.
His responsibilities extend to the issuer for advice, aid in financing,
and determination of sound financial practices. To his investing
clients he is responsible for thorough investigation of the issuer
and its securities, selection of sound issues, formation of invest-
ment judgment, and aid in maintaining a market. He thus plays an
extremely important role in capital formation by making available
to business concerns and public bodies the funds required for the
operation and growth of the economy, obtaining these funds from
the savings of many millions of investors, directly and through
1 To participate in a small way in such business, some investment houses act as
intermediaries, on a fee basis, between the borrowing corporation and the invest-
ing institution.
INVESTMENT BANKING
215
financial institutions. It is important that he conduct his affairs
honestly, efficiently, and economically.
Something of the economic importance of the investment
banker, as well as the methods used in the distribution of securi-
ties, is indicated by the following figures covering all securities
registered for cash sale with the Securities Exchange Commission
for the fiscal years ended June 30, 1949 and 1950 (in millions of
dollars): 2
1949 1950
To be sold through investment bankers:
Under agreements to purchase for resale . . . $2,758.4 $2,927.8
Under "best-efforts" agreements 557.4 962.8
$3,315.8 $3,890.6
To be sold directly to investors by issuers .... 888.2 490.7
Total $4,204.0 $4,381.3
Business functions of investment banking. The chief function of
investment banking is the distribution of new issues of securities.
The position of the investment banker in the commercial world
is similar to that of the merchant who buys goods on a wholesale
basis and resells them at retail. Just as some of the larger mer-
cantile houses conduct a wholesale business with smaller firms,
so the larger investment banking firms act as wholesalers in sup-
plying securities to smaller dealers. The investment banker who
deals in securities performs the economic function of the merchant
who deals in commodities. In both instances, middlemen are
needed in order to make the articles readily available to buyers.
Both have an equal economic justification. Criticism is warranted
in either case only if the service is inefficient or if the compensa-
tion is unreasonable.
In acting as merchants who are engaged in the business of
distributing securities, investment bankers differ from commercial
bankers, who act primarily as the custodians of funds which have
been deposited with them. The commercial banks, in loaning these
funds, are, in effect, using capital which belongs to other people
and which they must be prepared to return at short notice.3 In-
2 Sixteenth Annual Report of the S.E.C., 1950, p. 6.
3 During recent years, commercial banks have been making "term loans" for
periods as long as ten years, in contrast to the traditional limit of one year for
bank loans. This innovation has enlarged the scope of commercial banking and
reduced the field of investment banking. (See Chapter 9.)
216
INVESTMENT BANKING
vestment bankers, who are not allowed to engage in deposit bank-
ing, must supply their own funds for use in purchasing securities.
Like merchants, they have placed their capital in inventories
which must be resold before additional securities may be pur-
chased. They buy for resale, not for investment, the obligations
of governments and corporations which are customarily sold to
investors and institutions other than commercial banks.
The investment banker should not be confused with the broker,
who is mostly concerned with executing transactions in securities
that are already outstanding, for the account of others. The in-
vestment banker should also be distinguished from the dealer,
who engages in the business of buying and selling securities for
his own account, through a broker or otherwise. In contrast with
the investment banker, neither of these as such plays any part
in the actual origination of new security issues, although they
may be involved in the retail distribution of such issues.
In actual practice, many brokerage houses maintain investment
banking departments, and many investment banking firms have
brokerage divisions and act as dealers in securities, both listed
and unlisted. A number of investment houses act as managers of
portfolios for investors, organize and manage investment trusts,
deal in government securities, maintain facilities for trading in
commodities, and conduct other activities as "department stores
of finance."
Types of investment banking houses. Investment banking
houses may be classified: as national or local, depending upon
their field of activity; as partnerships or corporations, depending
upon the form of organization; as underwriters or distributors,
depending upon the volume of business handled. Although many
of the larger investment houses (such as Halsey, Stuart and First
Boston) do a nationwide business with offices in the principal
cities, some of the very largest have no out-of-town offices (such
as Morgan Stanley and Kuhn, Loeb). Investment banking firms
which have memberships on the New York Stock Exchange are
required to operate as partnerships, but those which do not have
such affiliation are usually corporations, except in the smaller
cases. Some firms conduct a purely wholesale business, while
others are wholesalers and large retailers combined. These firms
are able to distribute relatively large portions of new issues and
INVESTMENT BANKING
217
usually join in the original underwriting in order to secure the
larger profit margin thus obtainable. Other firms are known as
distributors, although the underwriting firms also act as dis-
tributors.
Internal organization. The internal organization of an invest-
ment banking house depends chiefly upon the size of the firm.
The larger houses, which handle a wide variety of issues on both
a wholesale and a retail basis, have departmental organizations
comparable to mercantile firms. The smaller houses necessarily
combine many activities into a few operating departments. From
a functional viewpoint, the work of an investment banking house,
as distinguished from that of a securities brokerage firm, may be
divided into five fields.
(1) The buying function is that of purchasingthrough under-
writing or otherwisenew issues of securities to be offered for
resale.
(2) The selling function is that of distributing either at whole-
sale through other dealers or at retail to the public, the securities
previously purchased.
(3) The advisory function is that of giving professional advice
to issuers and buyers of securities, based on information com-
piled by the statistical or research department.
(4) The protective function is that of protecting the interests
of holders of securities through the provision of secondary mar-
kets and the reorganization of companies in trouble.
(5) The service function is that of performing a number of
miscellaneous services for the convenience of the investor.
Private negotiation and competitive bidding. Securities are
obtained by investment banking houses either through privately
negotiated sales by the issuer to the bankers, or through com-
petitive bidding. Under the former method, an investment bank-
ing house, or, more frequently, a group of participating houses,
acquires the issue from a corporation in a private deal. The sale
may go to a particular banking house because of previous satis-
factory services performed. Or the origination of the issue by a
particular firm may result from the search for new issues, or from
relations with other bankers. New financing proposals may also
reach investment banking houses through the direct application
of the corporation seeking funds.
218 INVESTMENT BANKING
The traditional custom of investment bankers in buying new
corporate securities through private negotiation has been very
considerably undermined by regulation requiring competitive
bidding for certain types of securities. It is estimated that ap-
proximately three-quarters of all corporate bonds, including
nearly all railroad and most utility bonds and virtually all state
and municipal bonds, sold through underwriters in the United
States, are now sold through this procedure. Few industrial bonds
are offered in this manner. In 1919 Massachusetts required elec-
tric and gas companies to offer their bonds through competitive
bidding. Since 1926, the Interstate Commerce Commission has
required this type of bidding for equipment trust issues of rail-
roads and, since 1944, for virtually all other types of railroad
securities. Certain state utility commissions, such as those of New
Hampshire, Indiana, California, and New York, require com-
petitive bidding for companies under their jurisdiction. In 1941,
under the Public Utilities Act of 1935, the Securities and Exchange
Commission adopted a rule (Rule U-50) requiring competitive
biddings for security issues of registered holding companies and
their gas and electric subsidiaries. Issues of less than $1,000,000
are exempt, as are issues sold pursuant to pre-emptive rights.
There is general agreement that competitive bidding is neces-
sary and appropriate in the case of municipal bonds. The main
reason for its extension to the sale of corporate securities has been
the desire to eliminate or lessen monopoly in securities under-
writing. Advocates of the practice also maintain that securities
will be better priced, commissions more reasonable, distribution
wider, and unwise dominance of corporations by their bankers
eliminated. The leading arguments (among many) against the
practice are:
1. The investment banker becomes a mere merchant and can-
not fulfil his responsibility to the issuer through advice on the
terms of the issue, the timing of the offering, and the appropriate
price.
2. Issues may become overpriced and consequently run the
risk of "stickiness" in anything but a very strong market.
3. Issues of poorer quality are encouraged.
INVESTMENT BANKING
219
4. Small dealers are discouraged from participating through
the decline in their portion of the gross commission.
5. Wider distribution cannot be expected when financing is still
concentrated in New York.
6. The investment banker cannot represent the interests of
the investor as well as through private negotiation, because of the
less complete investigation, lack of advice to the issuer, and pos-
sible overpricing of the issue.
The buying function. The buying department of a large in-
vestment banking firm is ordinarily organized into three divisions:
corporate, municipal, and foreign. The smaller underwriting firms
have either corporate or municipal buyers. The firms which act
as distributors rather than underwriters do not have buying de-
partments, inasmuch as the new securities they offer for sale are
obtained from underwriting firms through sales agreements.
Although numerous foreign securities were underwritten by
American houses in the decade from 1920 to 1930, the flotation
of such issues has virtually stopped, with the exception of Cana-
dian offerings. (See Chapter 22.) The cessation of foreign issues
in the 1930's was due in part to political and economic troubles
abroad, in part to international hostilities, and in part to the effect
of the Johnson Act of 1934, which prohibited loans to nations in
default on World War debts to the American Government. World
War II virtually completed the drying-up of foreign loans in the
form of dollar bonds. In the 1920's it was the practice of American
investment houses in the purchase of foreign securities to send
buying representatives to conduct negotiations in the countries of
issue rather than to deal with an authorized negotiator in this
country. Competition between rival investment firms for the privi-
lege of making the loans was not conducive to the most conserva-
tive lending practices or to the best interests of American investors
who purchased the bonds^(See Chapter 22.)
Municipal securities are purchased through competitive bid-
ding. The municipality advertises its issue in a daily newspaper
or in The Bond Buyer, stating the terms of the issue and calling
for sealed bids. Usually the bid showing the lowest net interest
cost to the issuer is accepted. When the proposed issue is larger
220
INVESTMENT BANKING
than single firms can handle, bids are placed for a designated part
of the issue. Because the aggregate price obtainable from the best
combination of partial bids is frequently less than the price offered
by bidders for the entire issue on an "all-or-none" basis, buying
firms usually offer group bids for the entire issue on joint account.
The work of the buying department in making a bid for a new
issue of municipal bonds is chiefly mathematical. After estimating
carefully the price which could be received from the sale of the
bonds to the public, with due consideration for interest rate and
maturity date, a profit differential is subtracted and a bid price is
determined. If it is assumed that the bonds could be sold on a
2.80 per cent yield basis, which would indicate a sales price of
104 ($1,040 per bond) for 3 per cent bonds at a 30-year maturity,
a profit margin of one point ($10 per bond) might be subtracted,
thus leaving an indicated bid price of 103 ($1,030 per bond). In
a strong municipal bond market, the profit margin might be cut to
% of 1 per cent ($7.50 per bond), indicating a bid price of 103.25
($1,032.50 per bond). As other bidders have probably calculated
along the same lines, the actual bids placed are seldom in simple
fractions but in involved decimals such as 101.5134, which is
slightly higher than 101.50 or 101.51 or even 101.513.
As indicated previously, most industrial securities are purchased
through private negotiations between the investment house and
the corporation. The usual procedure of an investment banking
firm in making an original negotiated purchase of a security issue
may be divided into three major steps. The first is the preliminary,
or office, analysis. The second is the engineering, legal, and ac-
counting examination. The third is the negotiation conference, at
which the final decision is reached.
The office analysis is a preliminary survey conducted at the
office of the investment banker and covers the financial statements
and the general character of the company. Many proposals do not
get beyond this stage.
If the preliminary analysis is favorable, the negotiations reach
the second stage, involving a very thorough investigation. Repre-
sentatives in the service of the investment house conduct a search-
ing inquiry into the internal affairs of the company. Appraisers
value the buildings, equipment, and inventories. Auditors verify
the financial records and inspect the accounting methods, with
INVESTMENT BANKING
221
particular regard to such important practices as depreciation
policy. Industrial engineers observe production methods. Market-
ing specialists analyze the distribution of the product and deter-
mine the position of the company in its field. Legal counsel passes
upon franchises, leases, and contracts. Reports on all of these
phases are received by the house, and, if they are favorable, the
negotiation conference is arranged.
At the negotiation conference an over-all informal agreement is
reached covering the amount of the issue and the provisions of
the securities that are best suited to the issuer's needs at the time
and that will meet the requirements of the market for the par-
ticular type of issue. A tentative schedule of the steps required
prior to actual public offering is drawn up. If the issue is to be
offered under the terms of the Federal Securities Act, a definite
public offering price is not set until a few days prior to actual
sale, but a price is agreed upon that may be subject to later
change. The underwriting spread or total bankers' commission is
also determined at this point. The margin to the investment house
is often low and the risk large. If the purchasing function is prop-
erly performed, however, the issue is, to use a maxim in financial
circles, "half sold." >j
The underwriting of securities. When negotiations between the
originating house and the corporation have been completed, an
agreement is drawn up between the corporation and the pur-
chaser. But large issues involve more risk than a single investment
house is willing to assume. Wide and rapid distribution is neces-
sary, and one house cannot afford to have a large portion of its
capital in one issue. For these reasons, while the negotiations be-
tween the originating house and the corporation are nearing com-
pletion, the former, acting as group manager, invites a group of
investment houses to share in the purchase. The number so invited
varies with the size and character of the issue and the current
condition of the securities market. It may range from as few as
two to over one hundred. An example of an extremely large group
is found in the case of the $200,000,000 issue of American Tele-
phone and Telegraph Company 2%% Debentures of 1982 brought
out in March, 1947, in which 199 houses participated. Only 15
underwriters participated in the purchase of $11,282,000 3)4%
mortgage bonds of 1975 issued by California Water Service Com-
222
INVESTMENT BANKING
pany in 1945. The financial responsibility of the participants, the
particular markets in which they specialize, their past records,
and their ability to distribute securities are the chief criteria for
their selection. The managing or originating house determines the
size of the individual participations.
Prior to the passage of the Securities Act of 1933, only the orig-
inating firm signed the purchase agreement with the corporation.
Under the present practice, the agreement is signed by the orig-
inating firm as the representative of all members of the purchase
group. Under the practices used prior to the Act of 1933, the
agreement was binding and guaranteed the issuer the entire net
proceeds of the financing, except under extreme circumstances.
The Securities Act introduced a required waiting period of 20
days between the filing of the registration statement and the effec-
tive date of public offering of the issue. As a result, current pur-
chase agreements, even if they take the form of firm commitments,
provide through "escape clauses" for the cancellation of the under-
writers' obligations under a variety of conditions.4 Furthermore,
the agreement to purchase is contingent on the registration state-
ment becoming effective, for without effective registration the
purchasers cannot publicly offer the security, if the offering falls
under the scope of the Securities Act.
The purchase agreement between the underwriters (purchase
group) and the corporation contains provisions covering the fol-
lowing: (1) title, amount, and complete description of the pro-
visions of the security; (2) various warranties by the issuer, in-
cluding full compliance with the Securities Act, proper accounting
certification, correct financial statements, absence of lawsuits
against the issuer, and qualification of the issue under state blue-
4 The prospectus dated June 28, 1949, offering Pacific Gas and Electric Company
3% First and Refunding Mortgage Bonds of 1983 contains the following statement:
"The purchase contract.. . provides in substance that it may be terminated by
the Representative with the consent of the Purchasers (including the Representa-
tive) who have agreed to purchase in the aggregate fifty per cent (50%) or more
of the principal amount of the Bonds (a) if, prior to the time the post-effective
amendment shall become effective, the market value of securities in general, or
political, economic or financial conditions shall have so materially changed as in
the judgement of the Representative to render it inadvisable to proceed with such
public offering, or (b) if, prior to the closing date, the Company shall have sus-
tained a material and substantial loss by fire, flood, accident or other calamity
which in the judgement of the Representative shall render it inadvisable to proceed
with the deliv ery of the Bonds, whether or not such loss shall have been insured."
INVESTMENT BANKING
223
sky laws; (3) the agreement of the underwriters to purchase and
of the issuer to sell the entire issue, usually with several liability
on the part of the underwriters, and the amount each underwriter
agrees to purchase; (4) the price of the issue, the underwriting
discounts or commissions, and the method of payment and de-
livery; (5) the agreement of the underwriters to make a public
offering within a fixed period after the effective date of registra-
tion at a stipulated offering price; (6) the agreement of the issuer
to pay all expenses in connection with the issuance and delivery
of the securities to the purchasers; (7) the agreement of the issuer
to deliver copies of the prospectus if required under the Securities
Act; (8) the agreement of the issuer and underwriters to indem-
nify each other against any liabilities under the Securities Act,
with certain reservations; (9) any limitation on obligations of the
underwriters, such as those arising out of adverse changes in the
condition of the issuer or in the market; (10) the furnishing of
certified financial statements by the issuer.
The purchase group (also known as the purchase syndicate or
underwriting syndicate) is tied together by a contract or "agree-
ment among underwriters" that is in effect a temporary partner-
ship agreement which sets forth the rights and liabilities of the
underwriters among themselves. It authorizes the originating firm
to act as agent and manager of the group (for which it is paid a
specified sum), stipulates the terms of payment by each under-
writer for his share of the issue, and contains provisions for
stabilizing the market, disposition of unsold securities, termination
of the contract, and the nature of the obligation or liability of the
members. In the "divided syndicate," now in universal use, the
liability of each member is limited to the amount of his participa-
tion.
On the date set for the completion of the terms of the under-
writing contract, the so-called "delivery date," each underwriter
delivers to the managing house a certified bank check made out
to the order of the corporation. These checks are delivered to the
corporation at a designated bank in exchange for the bonds, which
are usually in the form of temporary certificates, called interim
receipts, exchangeable later for definitive bonds. Underwriting
firms "take down" only that part of their subscription which they
plan to sell direcdy and leave the remainder for distribution to
224
INVESTMENT BANKING
members of the selling group, from whom they will receive reim-
bursement through the underwriting managers.
Pricing the issue; the underwriters' "spread." A most important
and delicate task of the investment banker is to set the price at
which the issue is to be sold to investors. To do this, he is guided
by the prices and yields prevailing in the market on comparable
issues. Underpricing deprives the issuer of funds that might other-
wise have been raised. Overpricing may result in large losses for
the underwriters. Thus, in May, 1950, a syndicate paid 98.5799
for 30 millions of debentures of Seaboard Air Line that were to be
resold at 99.375. The bonds found few takers, and when the syndi-
cate let the bonds reach their own level, the best price they could
obtain was 97.5, resulting in a loss to the group, before expenses,
of over $300,000.
The price must also reflect the underwriters' spread or com-
mission. Spreads vary with the size, type, and quality of the issue,
with the anticipated ease of distribution, and with market con-
ditions. They may be one per cent (one point) of face value or
less in the case of a municipal bond that is readily marketable,
from less than one per cent to 2 per cent on high-grade corporate
bonds, and to as high as 20 per cent on unseasoned stocks that
require intensive sales effort and greater risk. Each new flotation
involves the reputation as well as the capital of the underwriters.
The cost of flotation, representing commissions and discounts
to investment bankers, on various types of securities registered
with the Securities Exchange Commission for public distribution
is shown in the table on the opposite page.
The spread or commission consists of three elements: (1) the
management fee of from % to & per cent in negotiated transactions
and 5 per cent of the gross spread in most competitive transac-
tions; (2) the compensation for underwriting of about 55 per cent
of the gross spread after allowing for the management fee; and
(3) the selling commission of about 45 per cent. Thus, in a nego-
tiated deal with 2 per cent over-all spread, management might
receive % per cent, % to % per cent might be retained by the under-
writers, and % per cent might be the compensation for selling. (It
is also customary to allow members of the National Association
of Securities Dealers, Inc., a "trade" concession of & per cent.)
Where an underwriter sells all or part of his participation to his
INVESTMENT BANKING
225
COMMISSIONS AND DISCOUNTS TO
INVESTMENT BANKERS
(Per cent of gross proceeds)
Year ended
June 30
Bonds
Preferred
Stock
Common
Stock
1941
1.8%
4.1%
14.4%
1942
1.5
4.1
10.1
1943
1.7
3.6
9.7
1944
1.5
3.1
8.1
1945
1.3
3.1
9.3
1946
.9
3.1
8.0
1947
.9
2.8
9.3
1948
.6
4.5
10.2
1949
.8
3.8
7.1
1950
.6
2.7
6.4
Source: Sixteenth Annual Report of the S.E.C., 1950, p. 7.
own clients, he would receive both the underwriting and selling
portions of the spread on all bonds taken up.
In most competitive bond transactions, the selling commission
is negligible, because the gross spread itself is very small. Most
securities purchased under competitive bidding have a very ready
resale, and the underwriting risk and distribution effort are cor-
respondingly slight. Thus, in the Pacific Gas and Electric Com-
pany issue referred to in footnote 4, page 222, the gross spread was
.506 per cent, of which the selling concession was .125 per cent.
Under the Securities Act of 1933 the amount of the commission
or discount to be retained by the underwriters must be fully dis-
closed in the registration statement and in the final prospectus
describing the offering.
"Best-efforts" selling. A deviation from outright purchase by
underwriters under a firm commitment is an arrangement whereby
the investment house takes no risk but merely acts as agent for the
company, agreeing to use its best efforts to distribute the securities
226
INVESTMENT BANKING
The following paragraph from the prospectus of December 10,
1945, offering a unit of 1 share of 6% preferred stock ($10.00 par)
and 1 share of common stock ($1 par) of Fleming-Hall Tobacco
Co., Inc., at the price of $15.00 per unit, illustrates the use of the
"best-efforts" arrangement:
The company has entered into an agreement with Floyd D. Cerf
Company (a sole proprietorship), 120 South La Salle St., Chicago 3,
Illinois (hereinafter called the "Underwriter") whereby the Company
employs the Underwriter to sell for its account 150,000 shares of 6%
Cumulative Preferred Stock and 150,000 shares of Common Stock of
the Company described herein, in units consisting of one share of Pre-
ferred Stock and one share of Common Stock at a price to the public
of $15.00. The Underwriter is not affiliated with the Company and
there is no commitment by the Underwriter to purchase any of the
units.
In this case the commission was $1.75 per share, or nearly 12 per
cent of the offering price. Selected dealers were to be allowed
$1.00 per unit for any shares passed along to and sold by them.
"Stand-by" underwriting. In its original or strict sense, the term
"underwriting" refers to an insurance function whereby under-
writers agree to take up the unsold portion of an issue that is being
offered by the corporation directly to the investor. The definition
of an "underwriter" contained in the Securities Act of 1933 in-
cludes both this arrangement and outright purchase by invest-
ment banks. The term "stand-by" or "pure" underwriting is used
to describe the former arrangement.
The most frequent use of the stand-by arrangement is found in
the issuance of stock or convertible bonds to present stockholders
under privileged subscription. Where the issuer does not wish to
incur the risk, an underwriting group is formed to stand by to take
any securities not purchased by stockholders. For this service a
commission is paid consisting of a certain rate on the whole issue;
an additional commission may be paid on all shares taken up by
the banking group. If stockholders subscribe to the whole issue,
the underwriters have been paid for their assurance that the funds
will be available when required and for advisory services. The
additional commission is in the nature of a real purchase-and-re-
sale discount.
In a study of 47 offerings to existing stockholders of common
stock listed on the New York Stock Exchange, made from Feb-
INVESTMENT BANKING
227
ruary, 1943, to October, 1946, 37 were underwritten and the
"stand-by" compensation (payment for commitment to purchase
unsubscribed shares) ranged from 5.6 per cent to 1.2 per cent of
the offering price, with an average of 2.78 per cent. In all but 8
of the 37, the agreement called for additional compensation on
unsubscribed shares purchased by the underwriters.5
That the underwriting of stock subscriptions may prove ad-
vantageous to the issuer and costly to the underwriter when the
offering is unsuccessful is illustrated in the case of the Willis-Over-
land $4.50 preferred stock, of which 155,145 shares were offered
to stockholders in June, 1946, at $100 per share. Only 6,024 shares
were taken up by stockholders, and the underwriters paid $98
for the balance. The stock declined to a low of $44 by September,
1947. At the opposite extreme is the very unusual arrangement
made in May, 1948, between Consolidated Edison Co. of New
York and Halsey, Stuart & Co. and associates, whereby the latter
(the underwriters) actually paid the utility company $1,000 for
the privilege of underwriting an offer of convertible debentures.
The investment banks in this case proceeded on the assumption
that there would be some debentures not subscribed for, which
the underwriters would be entitled to purchase at par and which
were expected to go to a premium in the market.
Selling the securities. Investment bankers are merchants of
securities. Once an issue is underwritten, it must be sold as rapidly
and as widely as possible in order to satisfy the issuer and limit
the risk of the underwriters. In the case of large issues, the usual
device for distributing the issue to the ultimate investor is the
selling group, formed to sell that portion of the issue not sold by
the underwriters directly to their own clients. The selling group,
or "representative dealers," consists of many dealers (sometimes
as many as several hundred), who are invited to enter into an
agreement entitling them to share in retailing the issue; they are
selected on the basis of their ability to obtain permanent place-
ment of the securities. The members of the selling group receive
the portion of the gross spread mentioned previously that is al-
lotted to the selling function on all securities passed along to them.
Under modern selling group arrangements, the members of the
6 The Financing of Stock Issues with Preemptive Rights (New York: Shields &
Co., February 1, 1947).
228
INVESTMENT BANKING
group are committed financially only for those securities for which
they elect to subscribe.
While invitations to participate in a selling group are sent out
early, the actual formation of the group, in the case of securities
whose offering is subject to the provisions of the Securities Act of
1933, is delayed until the effective date of the registration state-
ment, before which no securities may be sold. In the interim, the
dealers are acquainted with the details of the forthcoming issue
by means of a preliminary or "red herring" prospectus which
differs from the final one in omitting the price at which the issue
.will be offered to the public or the concession (share of the
spread) that will be allowed the members of the selling group.6
The arrangements between the purchase group and the selling
group are set forth in a selling group agreement in the form of a
letter from the manager to the selling group members. It includes,
among other matters, the offer of a specific amount of securities
to the invited dealer, the public offering price, and the amount of
the dealer's concession, together with provisions for terminating
the group. The securities cannot be offered to the public below the
public offering price during the life of the group, which, under
present-day practice, seldom exceeds one month. Not all offerings
are quickly absorbed, however. Because of unforeseen market
conditions or because they have been overpriced, new issues oc-
casionally become difficult to sell, or "sticky," in financial parlance.
It is the invariable practice of underwriting groups to "support
the market" while offering new securities. In order to avoid the
harmful effect of reported transactions at prices lower than that
set in the public offering, the underwriting manager places buying
orders in the market for the purchase of the bonds at the public
offering price. Similar buying orders are sometimes placed for the
purchase of other securities of the same company if these issues
seem more attractively priced than the new issue. As a conse-
quence, the market price of a new issue is not allowed to fall be-
low the established price during the period of distribution. Even
6 The term "red herring" is derived from the fact that each page of the prospectus
contains a statement, printed in red, that the information is subject to correction
and that the document is not an offer to sell or a solicitation of an offer to buv the
securities described.
INVESTMENT BANKING
229
though such market stabilization is a form of price manipulation,
if has been approved as an essential part of security distribution.
However, two rules must be observed: (1) notice of the intention
to support the market must be included in the prospectus; and
(2) daily reports of stabilizing operations conducted to facilitate
the distribution of a registered security must be made to the
Securities and Exchange Commission.
New issues of securities are ordinarily sold through direct solici-
tation of salesmen employed by the investment dealers, who are
compensated on a commission basis. The natural consequence is
that salesmen seek a maximum volume of business, and there is
sharp temptation to induce clients to switch from old into new
securities, or to buy securities that may not be suited to their in-
vestment needs. In fairness to the investment house, investors
should realize that all securities offered by that house are not of
uniform quality and are therefore not equally suitable for all
buyers. As explained throughout this book, securities range in
quality from very good to very poor. While reputable investment
houses naturally avoid poor securities, yet they do not confine
themselves to those of the highest grade. The more conservative
houses instruct their salesmen not to offer securities indiscrimi-
nately but to recommend issues suitable to the position of the in-
vestor. Investors, in turn, should not assume that all securities
offered by a house in which they have confidence are desirable
commitments for them. The proper selection of investment se-
curities is among the most important problems of the investor.
He should seek advice but should also be prepared to make his
own decisions.
The advisory function. Investment houses act in an advisory
capacity with relationship to issuers of securities as well as to
buyers of securities. A corporation that desires to raise capital
through the sale of securities will consult with the investment
house which usually handles its issues before determining the na-
ture of the offering. The investment house is constantly in touch
with market conditions and is in a position to recommend the
type of security that will prove most popular under existing con-
ditions. Moreover, provision must be made for future needs and
market conditions, as well as for those of the present. The manner
230
INVESTMENT BANKING
in which this advisory function operates has been explained by a
prominent investment banker: 7
When a company desirous of raising capital funds first goes to an
investment banking firm, the company frequently has not even decided
what type of security it wishes to offerwhether, for example, it should
be a mortgage bond, a convertible debenture, a collateral trust note,
or a preferred or common stock. The issuer is seeking advice on that
primary question and also on the related questions of the terms (such
as probable price, maturity, and interest rate), the amount of money
to be raised, and the time best suited for the offering. Such problems
must be considered not only with the existing financial structure of
the issuer in mind, but with an eye to the future. They are often studied
jointly by the banker and the issuer for months. Some are frequently
decided promptly; others (such as the public offering price, interest
rate, conversion provisions, and redemption terms) cannot be finally
fixed until a day or two before the issue is placed on the market. If the
securities are to be issued under a trust indenture, weeks may be spent
in considering the covenants and other provisions that it should con-
tain for the proper protection of both the issuer and the investor.
Investment houses endeavor to act in an advisory capacity to
investors in various ways. They are always willing to discuss the
suitability of a particular security to the needs of the inquiring
investor, either in personal consultation or by correspondence.
Many houses invite their customers to submit investment lists for
periodical examination, on the basis of which recommendations
are made for changes they believe will be beneficial. Most houses
will cheerfully prepare an analysis of any security in which a
customer may be interested, even though the firm may have no
interest in the issue. Charges are seldom made for these services
beyond the profit obtained on securities bought through the house.
The protective function. Investment houses usually act to pro-
tect the interests of customers in securities issued by the house
which later meet default. They form protective committees which
endeavor to arrange the most equitable settlement on behalf of
the security holders. In the words of an outstanding investment
banker: 8
7 From a memorandum submitted by Harold Stanley, of Morgan Stanley and
Company, to the Temporary National Economic Committee, dated Nov. 29, 1939.
s From testimony of the late Otto H. Kahn, of Kuhn, Loeb & Co., in the Con-
gressional Investigation of Foreign Loans, December 21, 1931.
INVESTMENT BANKING
231
The issuing house considers it its responsibility to do everything in
its power to reconstitute and re-establish the solvency and good credit
of the property; to protect the bondholders against any undue exac-
tions that might be demanded of them; to work out the best possible
plan of reorganization, and to give advice in all fairness to the bond-
holders concerned; to give its efforts, its experience, its ability fairly
and properly to deal with the situation after the default has been
created.
As a further method of protecting the interests of their cus-
tomers, investment houses usually maintain trading departments.
These departments provide what is called a "secondary market"
for securities originally sold by the firm which customers desire
to dispose of. In all cases where securities are received on an ex-
change basis, the credit allowed to the customer depends upon the
price the house can obtain through its trading department, which
keeps in touch with the various security markets. The trading de-
partment usually "makes a market" in securities previously issued
by the house, by maintaining bid and asked prices in the issues.
Orders for the purchase and sale of securities not issued by the
house are handled through this department. Requests for price
quotations from customers are likewise answered by this division.
The work of the trading department is especially valuable in con-
nection with unlisted securities, because of the lack of reliable
quotations in this important group. Unlike the trading department
of a brokerage house, which is operated for the prime purpose of
direct profit, the trading department of an investment house is
maintained principally to assist the sales department in the dis-
tribution of new issues.
The service function. Investment houses perform many minor
services of considerable benefit to the customers who take ad-
vantage of them. They protect securities in their vaults in special
safekeeping envelopes. They collect interest and dividend pay-
ments when so requested. They notify investors of called bonds
and of opportunities to profit from sinking fund offers or conver-
sion options. They keep files of customer security holdings and
stand ready to make suggestions for the improvement of portfolios.
They maintain statistical departments that contain official sources
of information available to customers of the house. They advise
the customers on income and estate tax problems in connection
with security holdings. It is not customary to make any charges
232
INVESTMENT BANKING
for these services, which are performed as part of the operating
facilities of the house.
Federal regulation of security selling. Legislation designed to
protect the public in the purchase of investments made a decided
advance in the passage of the Securities Act of 1933. So far-reach-
ing are the provisions of this law that it is not an exaggeration to
state that it represented the passing of an old order and the be-
ginning of a new epoch in the business of security marketing. As
aptly remarked by President Roosevelt in recommending such
legislation, the old slogan of "Let the buyer beware" has been
amended to "Let the seller also beware." No longer may "hedge
clauses" be inserted in security circulars for the purpose of releas-
ing the investment house from any responsibility for the accuracy
of information given. The obligation of telling the whole truth in
connection with new security offerings has been placed upon the
issuing corporation and the distributing investment house.
The Federal Securities Act does not automatically eliminate
state security commissions and blue-sky laws, or interfere in the
security-approval functions of the Interstate Commerce Commis-
sion or the state public service commissions. The Federal law aims
to supplement existing state laws which have not proved suffi-
ciently rigorous in preventing severe losses to the investing public.
It applies only to securities offered through the mails or in inter-
state commerce.
The purpose of this discussion is to indicate the nature of the
protection afforded by the statute rather than to summarize the
provisions of the entire Act. In general, the law requires that
specific information on new security offerings be filed with the
Securities and Exchange Commission prior to the sale of such
issues to the public and that the issuers of the securities be held
responsible for the completeness and accuracy of such information.
Exempt securities. Certain classes of domestic securities are
exempted from the provisions of the Securities Act. The list of
such issues is here shown:
1. United States Government obligations;
2. Territorial bonds;
3. Federal instrumentalities, such as Federal Land Bank bonds;
4. State bonds;
INVESTMENT BANKING
233
5. Municipal bonds;
6. Securities issued by railroads and other common carriers;
7. Receiver's and trustee's certificates, issued with court ap-
proval;
8. Certain issues aggregating less than $300,000 if regulations
of the Commission are complied with;
9. Securities of savings and loan associations and banks;
10. Securities issued in exchange for old securities in a reor-
ganization or recapitalization.
Exempt transactions. Certain kinds of transactions are exempted
from the Securities Act:
1. Transactions in new issues, not through an underwriter and
not involving a public offering;
2. Transactions by persons other than issuers, underwriters,
and dealers;
3. Brokerage transactions, executed upon unsolicited customers'
orders.
Registration statement. Before new securities may be offered to
the public, a registration statement, which becomes effective 20
days later, or earlieras the Commission may determinemust
be filed with the Commission. This statement must be signed by
designated officials of the company, and copies must be made
available to the public. The Commission has the right to issue a
deficiency statement or to serve a stop order in any case where
it appears that the statement is incomplete or inaccurate in any
material respect. The law requires that the registration statement
give specific information on no less than 32 designated points,
among which are the following:
1. Purpose of issue;
2. Price at which offered to the public;
3. Price at which offered to any special group;
4. Disclosure of any purchase option agreements;
5. Promotion fees;
6. Underwriting profit;
7. Net proceeds to the company;
8. Remuneration of any officers receiving over $25,000 annu-
ally;
234
INVESTMENT BANKING
9. Disclosure of any unusual contracts, such as managerial
profit-sharing;
10. Detailed capitalization statement;
11. Detailed balance sheet;
12. Detailed earnings statement for three preceding years;
13. Names and addresses of officers, directors, and under-
writers;
14. Names and addresses of stockholders owning more than
10 per cent of any class of stock;
15. Copy of underwriting agreement;
16. Copy of legal opinions;
17. Copy of articles of incorporation or association;
18. Copies of indentures affecting new issues.
A separate group of 14 requirements is provided in connection
with new issues of foreign governments and subdivisions. The
requirements include the following:
a. Purpose of issue;
b. Complete debt statement;
c. Default record for 20 preceding years;
d. Revenues and expenditures for 3 preceding years;
e. Net proceeds from securities sold in United States;
f. Price to the public;
g. Cost of distribution (underwriting fees);
h. Copy of legal opinions;
i. Copy of underwriting agreement.
The prospectus. The term prospectus is applied to the docu-
ment supplied to the investor which offers a security for sale.
The information contained in the prospectus must coincide with
that in the registration statement, with the omission of certain
technical features, as stated in the law and as determined by the
Commission.
Injunctions and criminal proceedings. Willful violations of the
Act are subject to injunction by the Commission, which may also
institute criminal proceedings against the violators in the Federal
courts, with possible fines and imprisonment.
Civil liability. In the event that the registration statement con-
tains any untrue statement of a material fact or omits any material
INVESTMENT BANKING
235
fact, any purchaser unaware at the time of purchase of such
situation may take legal action, within three years, for recovery
of loss against the persons mentioned in the statement as officers
or directors of the company, as professional advisers, or as under-
writers. To escape liability such persons (other than the issuer)
must prove that after reasonable investigation they had no rea-
sonable ground for belief that the information was incomplete
or inaccurate. Damages may not exceed the price at which the
security was offered to the public.
Financial statements. In connection with the balance sheets
and earnings statements required in the registration statement,
the Federal Commission is empowered to prescribe the forms in
which the information is to be submitted, the items to be shown,
and the methods to be followed in the preparation of accounts
in the appraisal of assets and liabilities, in the determination of
depreciation and depletion, and in the differentiation between
charges to capital account and to operating expense.
Speculative securities. The purpose of the Securities Act is not
to prevent the sale of speculative issues, but rather to stop the
sale of fraudulent securities and to place before the investor all
the facts necessary for intelligent judgment of the merits of the
issue. Investors must rely upon their own opinions in arriving
at a decision to purchase. The position of the Federal Commission
in this important respect has been officially stated as follows:
The public should thoroughly understand that the commission is
not authorized to pass in any sense upon the value or soundness of any
security. Its sole function is to see that full and accurate information
as to the security is made available to purchasers and the public, and
that no fraud is practiced in connection with the sale of the security.
Speculative securities may still be offered and the public is as free
to buy them as ever.
The commission's duty is to see that the security is truthfully pre-
sented to prospective purchasers. The fact that a description of the
security and of the concern issuing the security is filed with the com-
mission is in no sense and must not be regarded as an endorsement or
approval of the security or the concern by the commission.
Appraisal of the Securities Act. It is difficult to evaluate the
disclosure provisions of the Securities Act. Many issues of se-
curities never get through the registration procedure, being
screened out by the inability or unwillingness of their promoters
236
INVESTMENT BANKING
to disclose the required information. How many other question-
able issues are never filed for registration because of inability or
unwillingness to disclose the facts will never be known. How
much reliance the average investor places on the copious informa-
tion available in the prospectus cannot be measured. At least, it
is there for him to use if he wishes to use it and can understand
it. But it is generally recognized that most individual investors
do not rely heavily upon it.
It is also difficult to appraise the effectiveness of the fraud
sections of the Act. An unknown number of persons have been
deterred, by fear of possible indictment, from interstate sale of
securities or use of the mails. But others have run the risk and
paid the penalty. Up to June 30, 1950, the Commission had ob-
tained convictions against 1,120 defendants in the criminal cases
developed by it.9
Special Federal securities regulation. The issuance of certain
securities exempt from the provisions of the Securities Act is sub-
ject to special regulation, notably that of railroads and other inter-
state common carriers. The purpose of issue, form of issue, and
disposition of funds raised through the sale of securities (with
certain exceptions) are subject to the control of the Interstate
Commerce Commission. Such regulation, like that of the financing
of utilities registered under the Public Utility Holding Company
Act of 1935 and those affected by state utility commission control,
is largely designed to assure conformity with sound principles of
finance. It is interesting to note that, although railroads are not
required to issue prospectuses in the form prescribed by the
Securities Act, similar documents are often used to describe rail-
road issues.
State securities regulation. State statutes, popularly known as
"blue-sky" laws, exist in all states except Nevada for the purpose
of protecting investors from fraudulent security offerings. These
laws lay down certain rules for the sale of securities within the
state and impose penalties for their violation. Some of them re-
quire the registration or licensing of distributors; others require
that securities be registered. In four states (Delaware, Maryland,
New Jersey, and New York) the statutes take the form of anti-
8 Sixteenth Annual Report of the S.E.C., 1950, p. 231.
INVESTMENT BANKING
237
fraud laws that do not regulate the sale of securities in advance
but enjoin and prosecute fraud when or after the issue has been
sold. State blue-sky laws exempt many types of securities.
The lack of uniformity of the state securities laws and the fact
that they applied only to issues within the state were important
among the reasons for the passage of the Federal law in 1933. In
general, the Federal law is much stricter. Yet it is interesting to
note that on occasions state securities commissions have been
"tougher" than the Securities and Exchange Commission. Two
states refused to permit the sale of the second issue of Kaiser-
Frazer common stock in 1946. Nineteen states turned down the
offering of Tucker Corporation common stock in 1947.
CHAPTER 15
SECURITIES MARKETS
Scope. The purpose of this chapter is to discuss the operations
of the markets for outstanding securities (in contrast to new se-
curities) and the respects in which they are regulated for the
protection of investors. The order of topics is: (1) functions and
classes of security markets, (2) functions of the exchanges, (3)
advantages of listing to the investor, (4) organization and opera-
tion of the exchanges, (5) the Securities Exchange Act, (6) the
Securities and Exchange Commission, (7) regulation of exchanges
and listed securities, (8) regulation of dealers and brokers, (9)
report requirements, (10) trading by "insiders," (11) proxies and
their solicitation, (12) credit control, (13) control of price manip-
ulation, (14) special offerings, (15) unlisted trading privileges,
and (16) the over-the-counter market and its regulation.
Functions and classes of securities markets. Security markets,
whether highly organized or not, exist for the purpose of assisting
buyers and sellers of securities to carry on transactions in art
orderly manner and at fair prices. In so doing they aid in the
mobilization of capital, the transfer of wealth, and the full utiliza-
tion of investment funds. The marketability that they give to se-
curities in varying degrees facilitates the ready conversion of
securities into cash, and at prices that reflect the consensus of
investment judgment at any particular time. It is important to
investors, to industry, and to the public at large that securities
markets provide breadth, continuity, and stability to security
transactions.
Two main classes of securities markets are found in the United
States: (1) the organized exchangescentral points where trans-
actions are conducted in listed securities on an auction basis
through brokers acting as agents for their customers; (2) the over-
the-counter, or unlisted, markets where prices are determined by
238
SECURITIES MARKETS 239
negotiations between buyers and sellers of securities on the one
hand and dealers on the other, or between dealers themselves.
The first of these two types of marketsthe organized exchanges
has traditionally been thought to provide numerous advantages
and closer prices than the unlisted market, but in recent vears
the distinction has become less and less unfavorable to the latter
type. In the first place, the number of unlisted issues has grown
tremendously during recent years with respect to quality as well
as quantity. In the second place, many unlisted issues have been
admitted to trading facilities on the securities exchanges with the
official approval of the Federal authorities. In the third place,
the investment firms which deal principally in unlisted issues
provide trading facilities comparable to the organized markets
for listed issues. In the fourth place, certain issues of undoubted
quality cannot, because of either small capitalization or limited
distribution, meet the listing requirements of the exchanges. And,
lastly, relatively reliable quotations on prices of many unlisted
securities are now obtainable in the daily newspapers.
The preference which investors have long shown for listed
issues has become somewhat outmoded in the light of these de-
velopments. So extensive has become the unlisted market em-
bracing issues of the highest quality, such as Treasury notes,
municipal bonds, and railroad equipment obligations, that even
the most conservative investors buy as freely from the unlisted
group as from the issues listed on the securities exchanges. Never-
theless, listing does provide some advantages that are outlined
below.
Function of the exchanges. Securities exchanges in the United
States are of the auction type in the sense that brokers for sellers
deal directly with brokers for buyers in competitive bidding and
offering. The broker for the buyer tries to obtain the lowest pos-
sible price, while the broker for the seller tries to obtain the
highest possible price; consequently, prices tend to change from
sale to sale according to the urgencies of the customers.
Members of the securities exchanges generally act as brokers
who execute orders sent to them by their respective clients. They
may, and often do, act as principals in purchasing and selling for
their own account. In the latter capacity, they are not permitted
to take advantage of their position in the filling of their own orders
240
SECURITIES MARKETS
but must give precedence to orders held for others at the same
price. Their principal advantage over nonmembers is the saving
in time effected by their actual presence on the floor of the ex-
change and the saving in commission charges.
The primary purpose of a securities exchange is to provide a
market for the exchange of seasoned issues.1 With the exception
of new issues of securities that are identical with thoseTalready
ou"fstanding, new capital is not raised through sale on the ^x-
changes. Indirectly, however, the exchanges aid corporations in
raising new funds by providing certain advantages to both the
corporation and the investor. To the corporation, the listing of its
securities adds marketability, may result in wider distribution of
the securities, and provides some publicity that may be of value
as long as the corporation is making a good record and the market
is stable. In addition, the more precise valuation of its securities
is an aid in determining the proper offering price of new issues
and in fixing the terms of exchange of securities in a merger or
consolidation.
Listing is not without some disadvantages to the corporation.
Compliance with the registration and reportings requirements for
listed securities is time-consuming, expensive, and imposes po-
tential liabilities that are avoided by purely over-the-counter
trading. The dangers of excessive speculative trading and possible
manipulation are also greater where the securities are readily
traded and subject to immediate pressure. A low valuation known
to all may also prove a handicap when the company is planning
additional financing.
Advantages of listing to the investor. The object of listing se-
curities is to gain marketability, and this is an advantage to the
investor as well as to the issuing corporation. A listed security can
be bought or sold on the exchange on which it is listedwhere
buyers and sellers are accustomed to meet, where the value of
the security is best known, and where the most favorable price
is obtainable. Moreover, if the investor is not immediately inter-
ested in buying or selling, he can keep in touch with the market
1 Leffler suggests three important functions of the exchanges: (1) to create a
continuous market; (2) to determine fair prices; (3) to aid in financing industry
(indirectly). G. L. Leffler, The Stock Market (New York: The Ronald Press Co.,
1951), pp. 51-57.
SECURITIES MARKETS
241
by observing the prices at which the security is being sold, as
reported in the transactions of the exchange. If he is an owner,
a downward .trend in the price may warn him that an exchange
is desirable and an upward trend may enable him to realize a
profit if he believes the movement is temporary. If he is not an
owner, repeated publication of current prices acts as a constant
invitation to buy, particularly if the price is attractive.
Listing adds to the collateral value of a security. In making
loans, banks prefer as collateral those securities that are readily
marketable. The bank is interested in the security not as an in-
vestment, but rather as a pledge that the loan will be paid. The
chief consideration of the bank is the relative convenience with
which the collateral may be converted into cash if the loan is not
paid. Bankers usually have neither the time nor the facilities for
investigating the intrinsic value of each security offered as col-
lateral, and therefore accept the market quotation as their chief
criterion. Listed securities enjoy a distinct advantage in this re-
gard.
The regulation of listed issues, the required publicity of the
affairs of the issuers of listed issues, and knowledge of price and
volume of trading add protection to the holdings in listed securi-
ties that may be very valuable to the investor. Generally speaking,
the more he knows about the company and the securities, the
better off he is.
Listing has much greater significance in the case of stocks than
in the case of bonds. It is customary to buy and to sell stocks
through the exchanges, whereas bonds are usually bought and
sold privately. Although the larger part of the shares of stock
bought and sold in New York is handled through the exchanges,
less than ten per cent of the bonds bought and sold are covered
in exchange transactions.
Organization of the exchanges. A stock exchange exists for the
purpose of providing a securities market open only to members,
who act chiefly as brokers for the buyers and sellers of the securi-
ties traded in that market. The exchange itself does not buy or
sell securities nor does it establish their prices. In essence, the
exchange is an auction market in which the buying and selling of
thousands of investors and traders produce a large volume of
transactions at the prices established by those transactions. Each
242
SECURITIES MARKETS
sale ends the auction of a certain lot of securities, and a new
auction is then started. There are no secret transactions, and
complete publicity is given to the bond and stock prices by means
of the stock and bond ticker tapes.
The New York Stock Exchange, whose origin can be traced back
to 1792, is the largest and most important of the exchanges and in
effect constitutes a national center for securities trading. It has
set the standards by which the other exchanges operate. The sec-
ond largest exchange, as measured by the number of listings and
the volume of trading, is the New York Curb Exchange. Ex-
changes exist in other cities to serve mainly as trading places for
securities with a more local interest.
There are 21 exchanges, of which 16 are classified as "national,"
being subject to the regulations of the Securities and Exchange
Act, while 5 are exempted. The activity of the registered ex-
changes is indicated by certain data concerning listings and trade
volume.
DATA ON EXCHANGE ACTIVITIES
(dollar figures in millions)
Exchange
Number of Issues
Registered
June 30, 1950
Market Value of
Trades, July 1949-
June 1950
Stocks
Bonds
Stocks
Bonds
1,479
922
$13,923.1
$866.1
429
11
1,283.8
40.2
375
11
359.4
.2
110
21
197.7
191
20
204.6
.6
141
173.2
.1
Detroit
114
65.1
Philadelphia-Baltimore
107
56
157.9
.9
96
1.3
SECURITIES MARKETS
243
The New York Stock Exchange, which serves as a prototype
of the other exchanges, is a voluntary association of 1,375 indi-
viduals who are the exchange members. Memberships may not be
owned by corporations. The individuals comprise three different
classes: (1) partners in about 600 commission houses (partner-
ships) devoted to the handling of orders on the exchange, con-
ducting business in about 400 cities across the country; (2) floor
traders and dealers operating for their own account; (3) capi-
talists or representatives of estates who maintain membership for
the convenience of trading and for the savings on commissions
resulting from the ownership of a seat on the exchange. The first
of these groups are individuals who represent what are called
member firms. The 2,300 other partners in these firms, not them-
selves members of the exchange, are known as allied members;
they cannot go on the floor of the exchange, they have no voice
in the management of the exchange, and their allied memberships
have no monetary value. The value of a seat or membership, how-
ever, has been as high as $625,000 (1929) and as low as $17,000
(1942).
Operations on the New York Stock Exchange. The activities
on the floor of the exchange are conducted by its members, whose
functions can best be described by a classification of the types of
brokers or dealers:
The commission broker executes orders for his firm on behalf
of its customers, at the established commission rates.
The floor broker transacts business on the floor of the exchange
for other exchange members who have more orders in different
stocks than they can handle alone. He shares the commission re-
ceived by the member firm.
The floor trader or dealer buys and sells on the floor of the ex-
change for his own account. He does not represent outside cus-
tomers or execute orders for other members of the exchange. He
derives his profit (or loss) from trading on relatively small price
fluctuations.
The specialist acts as both broker and dealer. As a broker, he
executes orders in one or a few stocks for other members of the
exchange; his work in this capacity is largely confined to limited
orders and others not subject to immediate execution. As a dealer,
he buys and sells shares in his special stock or stocks, subject to
244
SECURITIES MARKETS
the rules of the exchange and of the Securities and Exchange Com-
mission.
The odd-lot dealer specializes in executing orders for less than
100-share lots; his compensation is the price differential of & or %
of a point added to or deducted from the round-lot price.
The bond crowd is a group of exchange members that executes
orders in and trades in bonds in a separate section of the exchange
floor.
Only those securities that have been listed can be traded on the
floor of the New York Stock Exchange, and under the Securities
Exchange Act of 1934 all of these must be registered with the
Securities and Exchange Commission. (On the New York Curb
and the regional exchanges, trading in unlisted securities provides
a substantial volume of business, under conditions explained later
in this chapter.) The policy of the Department of Stock List is to
restrict the privilege to seasoned issues of established, substantial
going concerns in which there is sufficient distribution and trading
interest to assure an adequate market. Securities of about 1,180
different companies are on the trading list, including about 650
bonds and 1,480 stocks. In addition, about 75 issues of Federal
and State government bonds are listed and about 190 security
issues of foreign governments. The market value of all stocks and
bonds listed on the Exchange is approximately $200 billions.
Securities Exchange Act. The securities exchanges of the
United States were brought under Federal control for the first
time under the provisions of the Securities Exchange Act of 1934.
This law created a Federal Securities and Exchange Commission
appointed by the President. It provides for the registration with
the Commission of any exchange as a National Securities Ex-
change. It forbids the operation of any unregistered exchange
except those which may be exempted by reason of a limited
volume of transactions. It places the control of the credit used in
the purchasing or carrying of securities with the Board of Gov-
ernors of the Federal Reserve System. It prohibits the manipula-
tion of security prices and the use of deceptive devices for such
purpose. It requires all companies which have securities listed
on the registered exchanges to file comprehensive information of
their affairs and to keep the information reasonably current. It
empowers the Commission to control the over-the-counter mar-
SECURITIES MARKETS
245
ket. It imposes severe penalties for violations. In short, it aims to
eradicate the more serious abuses in securities trading that char-
acterized the period of the 1920's.
The Securities Exchange Act of 1934 may be regarded as a
logical supplement to the Securities Act of 1933. As we have seen,
the purpose of the Securities Act is to provide adequate protec-
tion to investors in the .purchase of new Issues7 The objective of
the Securities Exchange Act is to safeguard investors in brokerage
transactions involving the purchase or sale of seasoned securities.
Through such legislation, the Federal Government has assumed
drastic regulatory control of the investment markets of the United
States.
The Securities and Exchange Commission. A Federal com-
mission, called the Securities and Exchange Commission, was
created for the purpose of administering the Securities Act of
1933 and the Securities Exchange Act of 1934.2 This commission
comprises five members appointed by the President and has wide
discretionary powers in the administration of the laws. Registra-
tion statements, listing applications, and periodic reports must be
prepared according to the detailed requirements of this Com-
mission. Important exemption powers are granted to the Com-
mission with respect to exchanges, securities, and reports. It has
assumed an importance in the investment business exceeding that
attained by the Interstate Commerce Commission in the field of
transportation.
Registration and regulation of exchanges. As one of the means
toward the securing of fair and orderly markets for securities, the
Securities Exchange Act requires that exchanges be registered
with the Commission as "National" exchanges or be exempted
from registration. At the present time, there are 16 registered and
5 exempted exchanges. The latter include very small exchanges
specializing in a few local issues.
In the registration statement, the exchange is required to pro-
vide full information concerning its activities, organization, mem-
bership, and rules of procedure, and to agree to comply with and
enforce the provisions of the Act. Registration brings the trading
rules of the exchange under the control of the Commission.
2 The jurisdiction of the Securities Exchange Commission under other statutes
is described in various other sections of this book.
246
SECURITIES MARKETS
Registration of listed securities. Transactions on National Se-
curities Exchanges are restricted to those securities which have
been officially registered with the Exchange and with the Com-
mission, or which are legally exempted under the provisions of
the law. The exempted group comprises, in general, public issues
of domestic origin, including Federal obligations and instru-
mentalities, and state and municipal bonds. Companies which
desire to have their securities listed on a National Securities Ex-
change must arrange registration by submitting detailed informa-
tion of their affairs at the time of application, and must agree to
keep such information reasonably current thereafter. The nature
of the required information is shown in the following summary:
1. The organization, financial structure, and nature of the
business.
2. The terms, position, rights, and privileges of the different
classes of securities outstanding.
3. The terms on which securities are to be and during the pre-
ceding three years have been offered to the public or otherwise.
4. The directors, officers, and underwriters, and each security
holder of record holding more than 10 per cent of any class of any
equity security of the issuer, their remuneration, and their inter-
ests in the securities of and their material contracts with the issuer
and any person directly or indirectly controlling or controlled by
or under direct or indirect common control with the issuer.
5. Remuneration to others than directors and officers exceed-
ing $20,000 a year.
6. Bonus and profit-sharing arrangements.
7. Management and service contracts.
8. Options existing or to be created in respect of their securi-
ties.
9. Balance sheets and profit and loss statements for not less
than the three preceding fiscal years, certified by independent
public accountants.
10. Trust indentures, underwriting contracts, articles of in-
corporation, and other documents and agreements as the commis-
sion may require.
The registration statements referred to above should not be
confused with those required under the Securities Act of 1933
SECURITIES MARKETS
247
described in the previous chapter. The latter describe the offer-
ings of new securities that are affected by the regulation of se-
curity issuance. The former are prerequisites to trading on a
national exchange.
Regulation of dealers and brokers. The Act empowers the Com-
mission to prescribe rules with respect to floor trading by ex-
change members and to prevent excessive trading off the floor
by members for their own account that would be detrimental to
the maintenance of a fair and orderly market. One of the main
problems has been to deal with the situation wherein the same
individual acts as an agent for a customer and also trades for his
own account as a dealer. Here the conflict of interest may abuse
the fiduciary relationship inherent in the brokerage function. The
Commission has promulgated no rules on this matter but has
aided in an advisory capacity in the drawing up of trading rules
by the exchanges themselves. The Act itself contains two rules
that apply to brokers and dealers generally, whether or not they
are exchange members: (1) a broker-dealer may not extend
credit to a customer on any security which was part of a new issue
in the distribution of which the broker participated within six
months prior to the transaction; (2) a broker-dealer must disclose
to the customer the capacity in which he is acting.
Report requirements. Issuers of securities registered on a Na-
tional Securities Exchange are required to keep the information
filed with the Commission and the Exchange "reasonably current"
and submit such annual and quarterly reports as may be pre-
scribed. These reports must be prepared in such detail and ac-
cording to such accounting procedures as are required by the
Commission. The Commission is empowered to prescribe the
methods to be followed in the preparation of the reports, in the
appraisal or valuation of assets and liabilities, in the determina-
tion of depreciation and depletion, in the differentiation of in-
vestment and operating income and of recurring and nonrecur-
ring income, and in the matter of separate and consolidated
income statements and balance sheets. The present rules govern-
ing the form and content of the financial statements filed with
the Commission under the Exchange Act of 1934 and the Securi-
ties Act of 1933 are found in the Commission's Regulation S-X.
The registration statements referred to previously and the re-
248
SECURITIES MARKETS
ports referred to above are available for public inspection at the
offices of the Commission. And the quality and quantity of the
information supplied in the company annual reports to stock-
holders has been greatly improved in recent years.
Trading by "insiders." Many investors have always been afraid
that officers and directors could exercise undue influence over the
prices of the securities of their companies and could take ad-
vantage of inside information at the expense of the investing
public. The Securities Exchange Act provides that each officer,
each director, and each owner of more than 10 per cent of the
equity securities of companies registered on a national exchange
must report changes in his holdings monthly. These changes are
in turn published by the Commission. And in order to prevent the
unfair use of confidential information, such persons are required
to account to the corporation for profits realized by them within
six months from any transaction in their company's stock. Such
profits are recoverable by the company by suit within two years.
Short sales by officers and directors are prohibiteda highly con-
troversial and unpopular section of the law.
Proxies and their solicitation. In order to promote more demo-
cratic and informed action on the part of company stockholders,
the Securities Exchange Act requires that any proxies sent out by
companies registered on a national exchange must be accom-
panied by a proxy statement that discloses fully the matters to be
voted upon, and that provision be made for voting either "Yes"
or "No" on all matters. Proxies may not be solicited until the proxy
material has been submitted to the Commission. The proxy state-
ments that now reach the hands of stockholders are often very
revealing. They include remuneration paid to officers and directors
and the stockholdings of the management.
Credit control. One of the features of the operations of the
capital markets prior to 1930 was the degree to which excessive
speculation was encouraged by the flow of bank credit into se-
curities transactions. Under the Securities Act, two provisions are
found that have greatly restricted the use of borrowed funds in
the purchasing and carrying of securities: (1) the Board of Gov-
ernors of the Federal Reserve System now fixes the margin re-
quirements for both banks and brokers. Since January 17, 1951,
the minimum margin (or equity) has been 75% on any registered
SECURITIES MARKETS
249
security (margin trading is described in Chapter 16); (2) ex-
change members, or brokers and dealers transacting business
through them, may obtain brokers' loans only from member banks
of the Federal Reserve System or non-member banks that agree
to comply with the restrictions on securities loans. The Securities
and Exchange Commission has the responsibility of enforcing
these rules.
Very high margin requirements have been bitterly opposed by
many brokers and dealers. Their precise effect is hard to evaluate,
but it is obvious that in a bull market the volume of business
handled by brokers is curtailed by such limitations on margin
accounts.
Manipulation of prices. It is very important to investors and
traders that the reported prices of securities be the result of legi-
timate and open trading. Whether the price of a security is high
or low, fluctuating or stable, it should represent the consensus of
buyers' and sellers' valuations without artificial influence. Pool
operations and manipulative practices were frequent in the 1920's
but, since the passage of the Securities Exchange Act, have largely
disappeared from the scene. The Act specifically prohibits five
types of manipulation:
1. Matched orders, or fictitious transactions by two or more
persons that create a price without any actual change of owner-
ship.
2. Wash sales, where one person "paints the tape" by ficti-
tiously buying and selling a stock at the same time, thereby
recording a price, but again without any change in ownership.
3. Pool operations, whose purpose is to raise the price of a
security (or depress it by short sales) through the concerted ac-
tivities of the members of the pool, followed by the unloading of
the stock to the public at a price influenced by the manipulation
and accompanying information concerning the security.
4. Dissemination of false information to the effect that the se-
curity will rise or fall as the result of manipulation.
5. The spread of false information concerning a security, for
example, incorrect information concerning the earnings of a cor-
poration, in order to induce its purchase or sale.
Short selling as such is not prohibited, except in the case of
250
SECURITIES MARKETS
officers and directors. There are, however, regulations concerning
the price at which a short sale may be executed (See Chapter 16).
Stabilizing of the price of an issue by its underwriters during a
public offering is a form of manipulation recognized by the Com-
mission, but one that is allowed under certain rules and regula-
tions (See Chapter 14).
Special offerings and secondary distributions. When very large
blocks of securities are to be sold by estates and other owners, the
market may be unable to "digest" them without seriously up-
setting the prevailing price. A procedure has been developed
whereby such blocks are offered after the close of the exchange
at about the closing price. But such transactions do not figure in
the volume of exchange trading for the day. Accordingly, under
special S.E.C. rules, such special offerings may now be made on
the floor of the exchange at a fixed price within the framework
of the existing auction market.3
A "secondary distribution" is the sale by dealers over the coun-
ter of a comparatively large block of listed securities when it has
been determined that it would not be in the best interest of the
parties involved to sell the shares in the regular way or by special
offering. Such distributions usually take place after the close of
exchange trading, at a net price equal to or below the most recent
exchange price.4 Such transactions by members of the New York
Stock Exchange must be approved by the Exchange.
Unlisted trading privileges. For many years, the New York
Stock Exchange has refused to admit to trading privileges any
securities not formally listed with it. But other exchanges, notably
the Curb Exchange, have admitted to unlisted trading privileges
a large number of securities that are not on its list but are listed
on regional exchanges. (The Curb Exchange does not trade in
New York Stock Exchange issues.)
An exchange may be authorized by the S.E.C. to continue un-
listed trading privileges in three groups of securities: (1) those
3 During the fiscal year ending June 30, 1950, 26 special offerings were made on
the New York and Curb Exchanges, involving the sale of 430,955 shares of stock
with a market value of $11,129,000. Sixteenth Annual Report of the S.E.C, 1950,
p. 30.
A During the fiscal year ending June 30, 1950, five exchanges reported having
approved a total of 78 secondary distributions under which 3,705,320 shares of
stock with a market value of $99,077,000 were sold. Ibid., pp. 30-31.
SECURITIES MARKETS
251
securities that enjoyed such privileges prior to March 1, 1934;
(2) those listed on another exchange and for which there is evi-
dence that there is adequate public distribution and sufficient
trading activity in the vicinity of the applicant exchange to justify
unlisted trading; (3) issues that are registered under the Ex-
change Act or the Securities Act of 1933.5
A large portion of the unlisted trading on regional exchanges
consists of trading in New York Stock Exchange-listed stocks,
especially in odd-lot business. In addition to such trading in stocks
listed elsewhere, multiple listing, whereby a stock is specifically
listed on more than one exchange, has grown rapidly in recent
years. As of June 30, 1950, 420 stock issues and 73 bond issues
were registered on two or more exchanges.6
The over-the-counter market. A very substantial number of
securities are not listed on any of the securities exchanges. Al-
though less important in aggregate value than the listed issues, the
unlisted or "off-board" group is much larger, because of the in-
ability or the unwillingness of corporations to gain listing privi-
leges for their securities. In interesting comparison with the
approximately 6,500 securities listed on the various national ex-
changes, there are about 60,000 additional issues in which an
active market is maintained throughout the country. Possibly 20
per cent of the stock business and from 90 to 95 per cent of the
bond business of the country is carried on over-the-counter. The
importance of the unlisted group is shown in the following list of
issues which are usually in this classification:
1. United States Treasury notes, bills, and bonds.
2. United States Territorial bonds.
3. Federal instrumentalities and agency bonds.
4. State bonds.
5. Municipal bonds.
6. Railroad equipment trust certificates and guaranteed stocks.
7. Many railroad bonds and stocks.
8. Many public utility bonds and stocks.
9. Most industrial bonds and stocks.
5 As of June 30, 1950, there were 877 stocks and 81 bonds admitted to unlisted
trading on the exchanges. Of these, 545 stocks and 6 bonds were listed on some
other registered exchange. Ibid., p. 32.
6 Ibid., p. 200.

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INVESTMENTS

LATE PROFESSOR OF FINANCE

NEW YORK UNIVERSITY

Generated on 2013-09-21 17:34 GMT / http://hdl.handle.net/2027/uc1.b5111849 Public Domain, Google-digitized / http://www.hathitrust.org/access_use#pd-google

Copymcht, 1920, 1924, 1934, 1941, 1952, by

70 Fifth Avenue, New York

Copymcht, 1933, by DAVID F. JORDAN

ALL RICHTS RESERVED. NO PART OF THIS BOOK

MAY BE REPRODUCED IN ANY FORM, BY MIMEO-

GRAPH OR ANY OTHER MEANS, WITHOUT PERMIS-

SION IN WRITING FROM THE PUBLISHERS.

First Printing September, 1919

Second Printing December, 1920

Third Printing February, 1922

Fourth Printing March, 1923

Fifth Printing January, 1924

FIRST REVISED EDITION

Sixth Printing September, 1924

Seventh Printing Fuly, 1925

Eighth Printing June, 1926

Ninth Printing January, 1927

Tenth Printing December, 1927

Eleventh Printing January, 1929

Twelfth Printing March, 19S0

Thirteenth Printing May, 1931

SECOND REVISED EDITION

Fourteenth Printing August, 1933

THIRD REVISED EDITION

Fifteenth Printing August, 1934

Sixteenth Printing August, 1935

Seventeenth Printing February, 1936

Eighteenth Printing AuguBt, 1936

Nineteenth Printing Tune, 1937

Twentieth Printing August, 1939

Twenty-first Printing June, 1940

FOURTH REVISED EDITION

Twenty-second Printing June, 1941

Twenty third Printing February, 1942

Twenty-fourth Printing January, 1946

Twenty-fifth Printing May, 1946

Twenty-sixth Printing August, 1946

Twenty-seventh Printing .... September, 1946

Twenty-eighth Printing February, 1947

Twenty-ninth Printing July, 1947

Thirtieth Printing November, 1947

Thirty-first Printing May, 1952

L. C. Cat. Card No. 52-8603

PRINTED IN THE UNITED STATES OF AMERICA

Generated on 2013-09-21 17:35 GMT / http://hdl.handle.net/2027/uc1.b5111849 Public Domain, Google-digitized / http://www.hathitrust.org/access_use#pd-google

PREFACE TO SIXTH EDITION

Many changes have taken place in the whole field of investments

on Investments. Had he lived, Professor Jordan would most certainly

influence of regulation, the increased interest in common stocks as in-

vestment media, and many other developments. It is the hope of the

from the clarity of style and presentation that characterized Professor

Jordan's original text.

respect to both organization and subject matter. The more important

of these are as follows:

ductory discussion of the nature of investment; Part II is devoted to a

survey of the media of investments, Part III to investment principles

and programming, Part IV to investment mechanics and the invest-

ment markets, and Part V to investment analysis.